Corporation versus LLC

This article is designed to help you figure out whether a corporation or an LLC (limited liability company) is best for your business.

In order to fully take advantage of this article, it is imperative that you have already decided that you want to organize your business in a way that will limit any personal liability. Once you've made that decision, though, you still have the problem of choosing which exact business structure would be best for you, pitting corporation versus LLC. Which one is going to be better for your business? Which one will be easier to create and maintain? Although this article cannot give you a firm answer one way or the other, it will attempt to show you the advantages and disadvantages of both corporations and LLCs.

Is an LLC Right for You?

Many small businesses may find that the flexibility and simplicity of a LLC makes it the better choice when it comes to forming as a corporation versus an LLC. If you plan on your business owning property, you will seriously want to consider forming your business as an LLC to avoid the problem of double taxes that may crop up if the business is formed as a corporation. This double tax problem arises if the business owns property that appreciates in value and the business is formed as a corporation. When this happens, both the corporation and the shareholders are taxed by the increase in property value when the property is sold or when the corporation is liquidated. Owners of an LLC, however, avoid this double taxation problem because the business' taxes are "passed-through" to the owners of the LLC, meaning the LLC is not a tax entity in itself and does not pay taxes on its income.

Is a Corporation Right for You?

There are also many instances when a LLC is not the best choice for a small business, however. There will often be other factors that make a corporation (C Corporation) the better choice when it comes to the corporation versus LLC decision. These factors could include:

• When you expect to have many investors in your business, or you plan on raising money for your business from the public. Although LLCs work great when there are only a few owners of a business that expect to have a hand in the dealings of the business, the LLC structure starts lacking when the number of investors and owners increases. At some point, the investors will want to have some sort of tangible ownership right in the business, which is where stock certificates come in. You can only issue stocks if you have organized your business as a corporation, however.
• When you want to provide other benefits to owners, like health insurance. Corporations are often able to provide benefits to those that are both employees and investors in the business. For example, if a person is both a shareholder of a business, and is also employed as the business' chief financial officer, the corporation would be able to pay that person a salary and also provide benefits like health insurance.
  Because of the setup of a corporation, the business will probably be able to deduct the costs of the health insurance from its profits, and the benefit provided to the employee is not considered income. This is a great benefit of forming your business as a corporation. To contrast, an LLC can only deduct a portion of the cost of the health insurance (and other benefits) premiums paid for the employees.
• You want to retain good employees. Unlike a LLC, a corporation has a great incentive system built directly into the structure of the business that can help small business retain great employees. Corporations can offer their best employees stock options that, in addition to providing an incentive for employees to remain with a business, also provide an incentive for an employee to continue working diligently for the business. Offering these stock options is an easier way to get employees a membership interest in the business, unlike LLCs where it can often be difficult and complex to get employees into the membership circle.

Is an S Corporation Right for You?

To figure out whether an S Corporation is right for your business, we must first explore the area of self-employment taxes. It is helpful to consider regular income taxes to figure out self-employment taxes. If you worked at a regular job, your employer would be required to withhold 6.4% of the first $106,800 you made for social security, and an additional 1.45% of earnings above that amount for Medicare taxes. The employer must add an equal amount and send that to the IRS for your income taxes (meaning that the total sent to the IRS is15.3% of the first $106,800 and 2.9% on anything past that). Likewise, in, 2009, only the first $106,800 of combine wages, tips and net earnings were subject to a 15.3% self-employment tax, and any earnings after that are subject to a 2.9% self employment tax.

Under an S corporation, you only pay self employment taxes on money you receive as compensation for your services, not on the profits that pass through the corporation to you. To make this clear, suppose you get $80,000 from your S corporation for the year, $60,000 of which was compensation for your services to the corporation. You will only pay taxes (15.3%) on the $60,000, not on the additional $20,000.

If your business were formed as a LLC, however, you may have to pay self employment taxes on the entire amount of business profits that pass through to you automatically.

There are currently proposed IRS regulations that would place self employment taxes on an LLC owner's entire share of the profits from the LLC in the following situations:

• When the LLC owner puts more than 500 hours into the LLC during the tax year,
• When the LLC provides professional services in the health, law, architecture, engineering, accounting, actuarial science or consulting field, or
• When the LLC owner can legally bind the LLC to a contract with his or her signature.

These are still just proposed regulations and have not been enacted by Congress, however. Until these proposals become law, however, you should assume that all of a LLC member's earnings will qualify to be taxed under self employment taxes.

In sum, a shareholder in an S corporation may be able to pay less self employment taxes than an LLC member. You should be aware that the IRS has been attempting to change the tax laws regarding LLC members, however, so you will need to stay abreast of this situation when considering how to organize your business.