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Tax Advantages of Filing as LLC, S-Corp and More

The format of your small business certainly impacts your financial performance. This is especially relevant as tax season approaches us.

Sole proprietorship

Many entrepreneurs establish their businesses as sole proprietorships.  Essentially, the person and the business are synonymous, and there is no legal distinction between the two. A fine example is a tax preparer who handles his/her clients’ filings with the IRS.

Advantages include having complete control over all the aspects of the business. Meanwhile, among the disadvantages are that raising capital may be difficult and that the business enterprise may be terminated if the owner becomes ill. Since the business is the same legal entity as the proprietor, it ceases to exist upon the proprietor's death. Because the enterprise rests exclusively on one person, it often has difficulty raising long-term capital.

Limited Partnership

Management of a limited partnership rests with the "general partner," who also bears unlimited liability for the company's debt and obligations.  A limited partnership allows for any number of "limited partners," whose liability is limited to the total amount of their investment in the company.

Limited partners are sometimes referred to as "silent partners" - in other words, they can make investments in the company but have no voting power or control over its day-to-day operations. They can be a valuable source of capital in this business structure.

Limited partnership is the entity of choice for many law, accounting and finance firms. It's also popular among businesses that focus on time-restricted projects, such as real estate and film production companies. Other advantages of a limited partnership include:

  • Personal asset protection: The limited partnership structure offers liability protection up to the amount of the investment for the company's limited partners.
  • Pass-through taxation: A limited partnership's income is not taxed at the business level. Instead, business profit and loss are "passed through" to the partners for reporting on their personal tax returns.
  • Full oversight: The general partner has complete management control of the business.
  • Investment potential: Limited partnerships can generate capital investments by adding more limited partners.

Limited Liability Company (LLC)

Forming a limited liability company (LLC) is a good way to "wall off" your personal assets from your company's liabilities. This business format offers protection of your personal property in the event of a judgment against your company.  Additionally, setting up an LLC provides an advantage in that the business itself is not responsible for taxes on its profits, as is the case with a corporation (C-Corp).

Instead, an LLC's owner reports profit and loss on his/her personal tax returns, similar to the tax reporting for a sole proprietorship or general partnership. This is known as "pass-through" taxation, and there is no need to file a corporate tax return. Owners report their share of profit and loss on their individual tax returns.

Another advantage is that the LLC does not have a residency requirement. Owners do not need to be U.S. citizens or permanent residents. This is one of the primary reasons that immigrant-owned businesses are established as LLCs.

A less monetarily tangible function of the LLC is that it provides enhanced credibility to prospective partners, customers, suppliers and lenders who might look more favorably on your business when you've formed an LLC.

S-Corporation

An S-Corporation (or "S-Corp") is quite similar to an LLC in that it offers a federal tax status that enables companies to "pass through" their taxable income or losses to owners/investors in the business, according to their ownership stake in the business.

By electing S-Corporation status, a company can eliminate the disadvantage of "double taxation" of corporate income and shareholder dividends associated with the C-Corporation tax status. Let's say a corporation makes $300,000 in a given year -- if it is an S-Corporation, the business itself will not be taxed for that amount. Instead, company shareholders would be required to pay taxes according to their percentage of ownership of the business.  In this scenario, if the company has three shareholders, each with an equal share of company stock, each shareholder will pay taxes on $100,000.

If the C-Corporation makes $300,000 in a year, then the company would pay taxes at the current federal corporate tax rate of about 34%. If the remaining profits of $198,000 are distributed to the three shareholders as dividends, each shareholder will pay taxes on $66,000 in dividend income at the current federal dividend tax rate of 15%.

In short, the S-Corporation status offers the following advantages:

  • Limited liability: Directors, officers, shareholders, and employees enjoy limited liability protection
  • Pass-through taxation: Owners report their share of profit and loss on their individual tax returns
  • Double taxation elimination: Income is not taxed twice (as corporate income and again as dividend income)
  • Investment opportunities: The company can attract investors through the sale of shares of stock
  • Perpetual existence: The business continues to exist even if the owner leaves or dies
  • Once-a-year tax filing requirement (vs. quarterly for a C Corporation)

C-Corporation

The most common type of corporation in the U.S. is the C-Corporation (of "C-Corp").  By forming a C-Corp, business owners create a separate legal structure that shields personal assets from judgments against the company. The structure of a C-Corp includes shareholders, directors, and officers.

The additional advantages of a C-Corporation are:

  • Limited liability: Directors, officers, shareholders, and employees enjoy limited liability protection
  • Unlimited growth potential through the sale of stock
  • No limit on the number of shareholders: Once the company has $10 million in assets and 500 shareholders, it is required to register with the SEC under the Securities Exchange Act of 1934
  • Certain tax advantages: including tax-deductible business expenses
  • Perpetual existence: The business continues to exist even if the owner leaves or dies
  • Enhanced credibility among suppliers and lenders

Drawbacks of the C-Corporation structure are that profits are taxed when earned and taxed again when distributed as shareholders' dividends. This is what's known as "double taxation." Shareholders in a C-Corporation also cannot deduct any corporate losses.  (To avoid these concerns, many small business owners choose to form an S-Corporation instead.)

Nonprofit Corporation

If your organization is involved primarily in educational, scientific, religious, or charitable endeavors, you’ll likely want to form a nonprofit corporation for the liability protections and tax advantages this status provides.

Incorporating a nonprofit will establish legal protections that can keep you and your directors’ personal assets separate from the company’s liabilities. There are other benefits to forming a nonprofit, as well.

In general, nonprofit corporations enjoy the following advantages:

  • Limited liability protection: Directors and officers are not personally liable for the organization’s debts and liabilities.
  • Perpetual existence: The nonprofit corporation continues even if a director leaves the business or passes away.
  • Eligibility for grants: Nonprofits may be eligible for public and private grants.

While nonprofits are bound by different state laws than for-profit enterprises, generally their formation processes are quite similar. Like a regular corporation, nonprofits must file Articles of Incorporation with the state in which they wish to incorporate. Additionally, the IRS requires organizations seeking tax-exempt status to file Form 1023. Several states also require organizations to file for state-level tax-exemption. The nonprofit status most commonly sought by organizations is the IRS’s 501(c)(3) tax-exempt status. The advantages of being a 501(c)(3) company are:

  • Tax-exempt status: Qualifying nonprofits can apply for federal and state tax-exempt status
  • Tax-deductible donations: Donations made by individuals to the nonprofit corporation may be tax-deductible
  • Enhanced credibility: Potential donors may be more inclined to give to an organization that has an official nonprofit status
  • Possible exemption from certain property taxes.
  • Reduced postage rates.

How a business is structured impacts taxation, ability to raise capital, personal liability in case of a judgment against the firm, and continuity in the case of an owner's death. Deciding on an appropriate company structure is important to the long-term operation and growth of the company. Consult with your accountant, or attorney to determine what is best for your situation, then consider contacting a service company to help you get started.

E.J. Dealy is CEO of The Company Corporation, the small business unit at Corporation Service Company® (CSC®), which incorporates tens of thousands of new businesses annually and provides ongoing compliance services to 200,000 companies located throughout the U.S.