When I address a group of business owners, I invariably get asked the unanswerable question, “For tax purposes, should I be a C Corp, an S Corp or an LLC?”
I wonder if a nutritionist feels this way when asked, “Should I go with a low-carbohydrate, high-protein or an all-cabbage diet?”
The question – the one about tax status, not the diet – is an important business decision and one I don’t feel comfortable sloughing off and deferring to their tax advisor. The decision has a long-term financial impact on the owner’s business and finances, and it involves more than just taxes. These six major considerations should be part of your conversation with your advisor team. If you have a handle on these issues, your advisors can better help you determine the best business structure strategy, including your tax structure.
1. Ignoring taxes, what legal structure makes sense for your business? Keep in mind that tax structure and legal structure aren’t necessarily the same. For example, an S Corp can be either an incorporated business or an LLC that has elected S Corp status. And, a corporation can be either a C Corp or an S Corp. So, before you decide tax status, you should first address what legal structure you want for your business. An LLC offers simplicity and flexibility. Incorporating, however, creates business perpetuity with centralized management. Even if you go with an LLC, you must decide whether the business will be “member managed” or “manager managed.” These non-tax issues are fundamental to doing business. Don’t let the cart get before the horse.
2. What state law considerations apply to your business? When I teach my grad students about incorporating a business, I have to mention states that follow the Model Act, the Revised Model Act, the Delaware law … and other regimes. Every state has both LLC and incorporation laws, but that’s where the similarity ends. Some states have special closely-held corporation rules that relax corporate formalities while others do not. There is not one standard LLC law any more than there is one uniform corporate law.
Other state-based legal issues fit into the mix as well. For example, in some states, an LLC structure offers added asset protection from creditors, and companies will try to be subject to these laws. In other states, professional firms are limited in what business structure they can elect. Additionally, due to state business taxes, the cost of doing business as a particular business entity varies from one state to the other. Some have franchise taxes on S Corps while others have such taxes on LLCs.
3. Who are the owners of the business? Before the “which way should I be taxed” question goes too far, consider the company’s ownership structure. Ownership, control and voting rights play important roles not only in the governance of the business but also in estate and tax planning for the owner. Depending on the owner’s financial needs, one business structure may offer flexibility that another business structure may lack.
S Corp rules in particular are precise about who can and can’t be owners. These rules limit the total number of owners to 100 individuals. The owners must be U.S. residents. And shares by and large cannot be owned by non-natural entities. LLCs don’t have these restrictions. C Corps on the other hand offer myriad options as to ownership, dividend participation, liquidation preferences and voting rights. It all comes down to what flexibility is needed and at what tax cost
4. How will payments be distributed? Deciding on salaries versus dividends is, again, like asking, “Should I focus my diet on carbohydrates or proteins?” It depends on the particular situation. The basic tax scenario is that wages are deductible to the company, but the employee is subject to income and employment taxes on those wages. Dividends and other owner distributions are not deductible. A complicating wrinkle is that if an LLC has chosen to be taxed as a partnership, potentially all distributions to owners can be subject to employment taxes. With an S Corp, however, only the owner’s wages are subject to FICA tax. So, a common issue for small businesses is whether to choose partnership taxation or S Corp taxation, not because of income tax, but because of payroll tax.
A company should consider how many owners are actually going to draw a salary and how much employment tax can be legitimately saved. In some cases, an LLC may fare better by continuing to be taxed as a partnership. For what little they lose in employment tax, they gain in flexibility – both in how they distribute profits and how they handle an exiting owner.
5. What is your fringe benefit structure? Fringe benefit taxation rules are generally better for C Corp owners than for owners of other businesses structures. Employees who have a 2 percent or more ownership in an S Corp and LLC don’t get to join in the positive tax advantages of several fringe benefit programs. For example, with group life insurance, salary continuation plans and health insurance, they have to recognize the employer premiums paid on these coverages in their personal income.
Similarly, owners of pass-through businesses such as S Corps and LLCs don’t enjoy the same tax benefits of nonqualified deferred compensation plans that that non-owners enjoy. For example, if you are a 25 percent owner of an S Corp that offers a nonqualified deferred compensation plan for its executives, one quarter of what you defer from your wages will just show back up in your share of K-1 income. Yes, you deferred taxes on a quarter of your wages, but that deferred salary returns to your tax return in the form of an owner share in profits.
6. What is your personal tax bracket? This has been a hot tax issue since the American Taxpayer Relief Act was passed in 2013. The issue is whether C Corp status might now offer some tax leverage that hasn’t existed for years. In the past, corporations and individuals shared the same top marginal tax bracket of 35 percent. Now, however, the top bracket for an individual is a combination of the 39.6 percent income tax bracket, plus the 3.8 percent surtax on net investment income – a potential 43 percent tax rate. This leaves an 8 percent spread between personal and corporate top brackets. For some high-income individuals, it may make sense to choose a C Corp structure to limit current income taxation to 35 percent. Yes, there will eventually be a tax to pay when earnings are distributed, but that may be a far-off event. In the meantime these owners enjoy a lower tax bracket and better fringe-benefit taxation.
C Corp, S Corp or LLC? It’s not as simple as the latest diet fad. And it’s a big decision not just a tax decision. Choose wisely.
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