3 Tax Differences Between LLCs And Corporations
Limited liability companies (LLCs) and corporations provide similar personal liability protections for their members, owners, or shareholders. So why choose one business structure over the other? Naturally, your choice to start an LLC or a corporation (or neither) will depend on numerous factors—whether or not your business ever intends to go public, for instance, or if your business intends to have only closely-related owners—but taxes certainly rank high on anyone’s list of considerations. This article discusses three of the most important tax differences between corporations and LLCs to help you make an informed decision about which business structure is right for you.
By default, the IRS treats corporations as taxable entities distinct from their owners, which means corporations usually pay federal income taxes on their profits before making dividend payments to shareholders (if the corporation pays out dividends at all), and the shareholders then pay taxes on those profits again as investment income. This is often called “double taxation,” one of the most maligned features of the corporation as a business structure. Limited liability companies, however, usually get taxed as pass-through entities (also called disregarded entities). This essentially just means that the IRS pretends the company doesn’t exist, at least when it comes to paying taxes, and treats the company’s profits as merely the owner’s or owners’ income.By default, the IRS will treat a single-member LLC as a sole proprietorship for tax purposes and a multi-member LLC as a partnership. In either case, the company’s profits and losses get reported on the owner’s or owners’ personal tax returns, though multi-member LLCs also file the U.S. Return of Partnership Income (Form 1065).
Qualifying corporations (of a certain size and nature) can also take the S corporation tax election and get taxed as a pass-through entity like the LLC, although the S corp election is also available to LLCs.
When you have an ordinary job working for someone else, your employer pays half of your social security and medicare taxes required by the federal government and withholds the rest from your paycheck. Self-employed individuals, however, must carry the entire tax burden themselves. This isn’t a significant issue for corporations because corporate shareholders don’t pay self-employment taxes on dividends or on capital gains earned from selling stock.The case is a bit different for LLCs. For LLCs that get taxed like sole proprietorships or partnerships, members usually pay high self-employment taxes on their portion of the LLC’s profits—surely one of the least attractive features of the LLC. If an LLC elects to get taxed as an S corporation, however, the LLC members will pay social security and Medicare taxes on a reasonable salary drawn from the company but not on their shares of the company’s profits.
One potential disadvantage of the LLC is that LLC members usually get taxed on the company’s profits even if they don’t actually collect those profits. That is, when LLC members decide to reinvest all or most of the company’s profits back into the company, they usually still get taxed as though the money ended up in their bank accounts. The effect is that members or owners can get placed into income tax brackets that don’t reflect the amount of money they take home each year.Not so with a business organized as a corporation. Under the corporate business structure, shareholders pay taxes only on dividends they actually receive, not the corporation’s profits, so reinvesting the corporation’s profits in the company can mean lower tax bills for shareholders at the end of the tax year. This is particularly advantageous for newer businesses more intent on growing in the long-term than merely filling their owners’ pockets.
Some Final Thoughts
When it comes to LLCs vs corporations, there are, of course, numerous other differences—tax-related or not. Certain types of employee benefits, for instance, are only available to one type of business structure or the other, and the administrative requirements and costs can differ widely between corporations, single- or multi-member LLCs, and organizations that elect to get taxed as an S corporation. Ultimately, when you decide to form a new LLC or corporation, the business structure you choose should be the one that encapsulates your company’s present necessities and future plans.