In order to evaluate corporations and partnerships, many consider taxation the most noteworthy difference. There are other distinctions worth highlighting. Plumb, Family CFO has compiled a list of definitions, featuring some pros and cons, with the help of accountants and tax advisors*.
How organizations are Taxed: A corporation, like any business entity, is formed by one or more persons to conduct a business venture and divide profits amount investors. A corporation files a charter or articles of information in a state, in a U.S. possession, with a foreign government, or with the U.S. government. It prepares by-laws, has its business affairs overseen by a board of directors, and issues stock. For tax purposes, the predominant forms of business enterprises are C corporations, S corporations, partnerships, and sole proprietorships. These different forms are treated differently under federal tax law and care should be taken in choosing the appropriate entity for the business.
C Corporations: are subject to the toughest tax bite. Their earnings are taxed twice. First, a corporate income tax is imposed on its net earnings. Then after the earnings are distributed to shareholders as dividends, each shareholder must pay taxes separately on his or her share of the dividends. A corporation can reduce, or even eliminate, its federal income tax liability by distributing its income as salary to shareholder-employees who actually perform valuable services for the corporation. Although this reduces taxation at the corporate level, employees who receive payments must still pay tax on the amount received.
S Corporations: Each shareholder of an S corporation separately accounts for his pro rata share of corporate items of income, deduction, loss, and credit in his tax year in which the corporations tax year ends. Certain items must be separately stated whenever they could affect the shareholder’s individual tax liability. A shareholder’s share of each item generally is computed based on the number of shares he held on each day of the corporations tax year.
The character of an item included in a shareholder’s pro rata share of S corporation income is generally determined as if the item was realized directly from the source from which the corporation realized it or incurred in the same manner in which the corporation incurred it, subject to exceptions. Thus, when the income passes through from the S Corporation to the shareholder, the character of that income passes through a well. For example, if an S corporation makes a charitable contribution to a qualifying organization, a shareholder’s pro rata share of the S corporation’s charitable contribution is characterized as made to a qualifying organization.
Definition: a “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization that carries on any business, financial operation, or venture, and that is not within the meaning of the Code, a trust, estate, or corporation.
Limited Partnerships: LP’s have one or more general partners and or more limited partners. Limited partners are not responsible for partnersip liabilities beyond the amount of their investments.
Limited Liability Company: LLC’s can be taxed as a partnership for federal income tax purposes. However, its members are not personally liable for the entity’s debts or liabilities.
This limited liability typically protects you from the personal risks involved if a lawsuit were to arise concerning your business — safeguarding your personal assets. A couple additional benefits of an LLC include:
• Flexibility in management. Corporations have a set management structure where directors oversee the major business decisions and officers are responsible for the day-to-day running of the business. LLCs do not have the same formal management structure.
• Pass-through taxation. With pass-through taxation, taxes are not paid at the business level. If you choose to become an LLC, income/loss would be reported on your personal tax return. If any taxes were due, they would be paid on the individual level.
Note the Differences
Once you understand the benefits that come from LLCs and S corps, it’s time to explore some of the pros and cons of each approach. Here are some of the key differences, according to Ebony Eka, CPA:
1. The owner of a single member LLC doesn’t have to file a tax return for the LLC, as they only report the activity on their personal tax return.
2. Ease of Set up: Most LLC forms are only a single page for single member LLCs.
3. Inexpensive to Start: The cost of setting up an LLC is also inexpensive, usually just a couple hundred dollars.
4. Guidelines: The red tape involved in forming an LLC isn’t as stringent as that involved with S corps, which also leads to savings on accountant and attorney fees, among others.
1. Self-employment Tax: Single Member LLC owners are required to pay self-employment tax on income generated in the LLC, which means making quarterly estimated payments to the IRS.
2. Owners of LLCs must make sure they don’t pierce the “corporate veil,” meaning they have to operate the LLC separately from their personal affairs. “The LLC must not be a shell but an operating entity,” says Eka. “There have been cases where a business owner lost their protection because there was no distinct difference between the LLC and its owner.”
S Corp Pros:
1. The key advantage of an S corp is that it offers tax benefits when it comes to excess profits, known as distributions. The S corp pays its employees a “reasonable” salary, which means it should be tied to industry norms, while also deducting payroll expenses like federal taxes and FICA. Then, any remaining profits from the company can be distributed to the owners as dividends, which are taxed at a lower rate than income.
S Corp Cons:
1. S corps have more strict guidelines than LLCs. Per the tax code, Eka says, you must meet the following standards to create an S corp:
o Must be a U.S. citizen or resident
o Cannot have more than 100 shareholders (a spouse is considered a separate shareholder for the purpose of this rule).
o Corporation can only have one class of stock
o Profits and losses must be distributed to the shareholders in proportion to the shareholder’s interest. For example, you can’t have disproportionate distributions of dividends or losses. If a shareholder owns 10 percent of the S corp, he or she must receive 10 percent of the profits or losses.
2. It costs more to form an S corp.
3. Shareholders must adhere to the requirements at all times. If they don’t, they risk disallowing the S corp election and the corporation would be treated as a C corp and its corresponding restrictions.
4. Passive income limitation: You can’t have more than 25 percent of gross receipts from passive activities, such as real estate investment.
5. There can be additional state taxes for S corps.
6. Shareholders should pay attention to paying themselves a “reasonable” salary for the work they perform for the S corp since the IRS is increasingly scrutinizing S corps for this.
Darren Dahl, Inc. Magazine
Ebony Eka, CPA – moneymentoringminutes.com
BizFilings: The Small Business Incorporation Experts