Corporation vs. LLC - Which is the Better Tax Organization Structure for a New Business?

When beginning a new business enterprise, one of the first issues to address is selecting the organizational structure. In many cases, this process will begin with a look at legal considerations such as the potential business risks and the entity type that is most likely to limit those risks.

While sole proprietorships and general partnerships may be the easiest entity structures to set up and operate, they both put personal assets at risk. On the other hand, a corporation presents an opportunity to protect personal assets and may be a good choice in many situations. And in recent years, the limited liability company structure has become increasingly popular.

Here are a few pros and cons of corporations and limited liability company structures.

Corporations

A corporation is a separate entity from its owners. A well-developed body of law covers personal liability protection as well as a variety of other issues which may be presented over the life of a business enterprise.

One of the important issues corporation owners face is the tax treatment of the entity’s profits. A regular corporation is subject to tax on profits at the entity level, with after-tax earnings subject to tax at the owner level when paid out in the form of a dividend. This double tax can be avoided by making an election to treat the entity as an “S” corporation, which allows the corporate level tax to be avoided; i.e., the earnings pass-through to the owners and are only taxed once.

In some circumstances, this may result in a higher incidence of tax since the owner’s tax bracket on the pass-through earnings may be higher than the rate that would apply if the entity were taxed as a regular or C corporation.

C corporation classification may present other practical benefits to owners. One notable advantage is simpler personal tax filings, since business tax reporting will have no direct impact on filing personal tax returns.

When deciding between C and S classification for a corporate structure, consider short and long term ramifications and evaluate the significance of tax consequences over the life of the business enterprise.

Limited Liability Companies

A limited liability company provides similar personal asset protection as a corporation. An LLC also generally provides tax benefits that are similar to an S corporation.

There are important distinctions, however. Earnings passing through from an S corporation will not be subject to social security or Medicare tax. However, earnings flowing from an LLC in which the owner provides personal services will be subject to such taxes; the so-called self-employment tax.

When a business generates losses that pass-through to its owners, basis provisions that limit the deductibility of such amounts are more lenient in an LLC. Entity level third party debt will not qualify as basis for S corporation owners but it can provide basis for LLC owners. Businesses that are equipment intensive or otherwise materially reliant on entity level debt in funding operating activities can be more suited to an LLC entity structure.

S corporations are also subject to some important limitations on the number and type of owners which do not apply to LLCs. These limitations may not be important at the inception of a business enterprise; however, they can present significant issues at a later time. For example, a business considering venture capital equity as a potential funding source may find an LLC organization structure more suitable, since these funding sources will violate the permissible owners provisions for an S corporation.

Selecting an LLC entity structure at the inception of a business can provide unique planning benefits arising from flexibility in organization structure over the life of a business enterprise. Many businesses may operate at a loss during the initial years, particularly when tax incentives for accelerated equipment cost write-offs may apply. In these cases, an LLC structure may provide better tax efficiency for owners, whereas basis limitations could apply for an S election.

Should circumstances arise over time that would make a C or S corporation tax structure more preferable, you can elect to change the tax classification of an LLC to a corporation without material adverse tax consequences. However, moving from either a C or an S corporation status to LLC status will typically lead to material tax impacts should business assets, including any value arising from goodwill, have a higher value than recorded on the books.