As a business and tax attorney I am frequently asked by clients whether a corporation or an LLC is a better entity for their new business. My response is that each entity has certain advantages and a review of the intended use for the new business and the goals of the owners/investors must be made before that question can be definitively answered.
The factors to consider include the following:
Organizational structure: From an organizational perspective an LLC’s owners are known as members, and the LLC may provide for managers who would have the management authority in an LLC. If the LLC does not provide for managers the members have all management authority and would sign all agreements and contracts on behalf of the LLC. A corporation’s owners are shareholders and they elect officers and the Board of Directors. The Board makes management decisions and the officers carry them out under their authority as contained in the bylaws. Some business owners like the familiar structure of a corporation with shareholders, officers and directors and their clearly defined roles and authority as opposed to an LLC with members and managers. An LLC Operating agreement can authorize the LLC members to elect officers with the authority listed in the operating agreement if the owners would like to form an LLC but have officers as customarily found in a corporation.
Liability protection: Both entities have the same liability protection for owners if properly set up and operated.
Federal Tax Differences: One significant difference between the two is the tax consequences. An LLC is a pass-through tax entity so that all profit and loss of the LLC is reported on the owner’s personal tax return and taxed at the owner’s personal tax rate. A single member LLC does not file a separate annual tax return as all revenue and expense is reported on Schedule C of the owner’s personal tax return, while a multi-member LLC must file an annual tax return with the IRS. An LLC is not required to hold an annual member meeting, unlike a corporation which is required to hold an annual shareholder and director meeting. Since a single member LLC does not file a tax return and does not have to conduct an annual meeting it is generally a less expensive entity to operate from an accounting and legal cost perspective.
A C corporation (a corporation which has not elected to be taxed as an S corporation) is a taxable entity and any net profit or loss is taxed in the corporation. Under current tax law the first $50,000 of net income left in the corporation is taxed at 15% and rates go up to 34%. This 15% rate is an attractive rate if the corporation intends to re invest earnings in the entity and build up the business. The corporation can later elect to be taxed as an S corporation, which is a pass through tax entity like an LLC, in which case the profit or loss is reported on the shareholder’s personal tax return, similar to an LLC. An S corporation provides an opportunity to pay less payroll tax on earned income if the owner takes earnings out of the corporation as an S corporation dividend rather than compensation since S corporation dividends are not subject to social security and Medicare tax. On the other hand all earnings from an LLC will be subject to 15.3% social security and Medicare tax for those members who have earned income from the LLC. The IRS has been paying close attention to payment of wages versus dividends so a taxpayer must be careful that they pay close attention to the law in this area.
When a C Corp converts to an S corporation the S corporation must wait ten years before it can sell its assets and avoid the gain at the corporate level. Because of this so-called built in gains tax, if a sale of the business assets is possible within ten years, you may want to elect S corporation status for the corporation at the time of formation to eliminate the ten year waiting period.
A single member LLC can be a shareholder of an S corporation as can grantor trusts but a testamentary trust or estate can only be an S corporation shareholder for two years.
Members of an LLC will receive a basis increase for third party loans to the LLC while shareholders of S corporations will not get a basis increase for third party loans to the S corporation even if they have personally guaranteed the loan.
Michigan Tax Differences: The new Michigan Corporate Income Tax of 6% of net income, which recently replaced the Michigan Business Tax, does not tax LLCs or S Corps, but does apply to C corporations once gross receipts exceed $350,000.
For more information, please contact Edward J. Castellani at 517.377.0845 or at firstname.lastname@example.org. The above information is not intended to be legal, tax, or investment advice. Please consult with your attorney on the issues described above and visit www.fraserlawfirm.com.