LLC or Corp? S, C, Disregarded, Partnership? A Quick Guide to Entity Tax Structures

Posted on: July 27, 2016 by in LLCs
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So I get a lot of questions about whether someone should open an LLC or a corporation. What are the differences, which is better for me, etc etc.

In this post I’m going to give you a quick run-down of the differences between LLCs and corporations and the different tax structures that can apply to each.

Corporations

Corporations are the gold-standard when it comes to entity formation. They have been around for centuries and the case law from that long history is very reliable. This means that there are very few surprises when it comes to owning and operating your corporation.

A corporation is legally a separate person from its owners. So a corporation can enter into contracts, do business, and all the other things you associate with being in business. This separation shields the owners from any liability that the corporation might create, with a few exceptions.

So for an example, let’s say a corporation owns a house. Somebody slips and falls on the sidewalk in front and decides to sue the owner of the house for not maintaining a safe walkway. If the lawsuit is successful then the only assets at risk are those owned by the corporation. Your personal assets as the owner of the corporation are not at risk – in most cases.

Of course, people always ask what the exceptions are. The separation of liability between the corporation and the owners is called the “corporate veil.” The veil can be “pierced” in certain circumstances: fraud or other illegal activity on the part of the owner, and not following the formalities.

The formalities are generally not a big issue. Each state has their own requirements to keep the corporation in current status. Usually it involves paying an annual franchise tax and keeping the address and such up to date. Additionally, you should be holding shareholder meetings at least once a year. For a single-owner corporation this amounts to having a meeting with yourself and documenting what you discussed.

Limited Liability Companies (LLCs)

LLCs are the new kid on the block when it comes to entities. The case law is not as settled as it is for corporations, but for the vast majority of people they work just like corporations as far as shielding the members/managers from liability.

LLCs became really popular in the 1990’s and 2000’s because they work very well for holding real estate because of a special quirk that allow them to be used on your personal tax return Form 1040 Schedule E-1 directly even though the member/manager doesn’t have any personal liability.

LLCs are “creatures of state law” according the IRS, which means that you have to tell the IRS how you want the LLC to be treated for tax purposes. This provides some nice flexibility that we’ll talk about below.

Like corporations, LLCs have to be kept in status, but do not have the same meeting requirements. So a lot of people like them for that extra layer of simplicity.

Tax Treatments

When it comes to how entities are treated for tax purposes, which is optimal for you will depend on your individual tax situation.

Here are some of the considerations:

C Corporations

A C corporation is a completely stand-alone entity. It makes money and pays its own taxes. There are no flow-throughs to the owners of the corporation.

C corporations are the only tax type that can have non-US taxpayer owners because the C corporation pays any taxes due.

Public companies and those seeking to raise money are typically C corporations.

A C corporation files a Form 1120 tax return each year.

An LLC or a corporation can elect this type of treatment.

S Corporations

S corporations given special tax treatment that small companies can elect. The profits or losses from an S corporation flows through to the individual owners’ tax returns on Schedule E-2.

S corporation profits and losses are considered passive and do not carry self-employment tax implications.

An S corporation files a Form 1120S tax return each year.

An LLC or a corporation can elect this type of treatment.

Partnerships

Entities that elect general partnership tax treatment have the same kind of flow-through as S corporations. But in this case the Active Partners are… active. So the profits/losses do carry self-employment tax implications.

A partnerships files a Form 1065 tax return each year.

An LLC can elect partnership tax treatment if it has at least 2 members, but a corporation cannot elect partnership tax treatment.

Sole-Proprietorships/Disregarded Entities

A single-member LLC is considered a disregarded entity by default. This means that its profits and losses are reported on Schedule C of your personal tax return.

These profits/losses do carry self-employment tax implications.

In most cases, this choice is sub-optimal.

LLCs can be used as disregarded entities, but corporations cannot.

Which is Right?

Everyone’s tax situation is unique. If you are interested in forming a corporation or LLC fill out the Incorporation or LLC Form. We will give you a call and discuss which entity type and tax treatment is best for your situation.

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