C corps, LLCs, and S corps differ considerably in the areas of taxation, ownership, structure, governance, fundraising, and employee compensation. The differences will dictate your choice of entity, depending on your scope of work and future business considerations. For example, a number of tax planning objectives to consider may include the following. Can assets move into and out of the entity without incurring a tax liability? How will the profits from the business be taxed, and are there opportunities to reduce and/or defer the tax? If the business generates a loss, can the loss be used to offset income from other sources? Can the owners of the business participate in the risks and rewards of the enterprise in different ways?
The primary taxation differences between C corps, LLCs and S corps are outlined below.
C Corps. Corporation is a taxable entity.
● Two Taxable Entities. A C corp is a separate taxable entity independent from its stockholders. Thus, the earnings of a C corporation are generally taxed twice: first at the corporate level on the corporation’s taxable income and a second time at the stockholder level on dividends or distributions.
Although the double-taxation feature of a C corp may be undesirable, its impact may be diminished where a company does not pay dividends or generates taxable income at a lower marginal tax rate than the rate applicable to the individual stockholders.
● Higher State Franchise Taxes. C corps often must pay higher state franchise taxes than LLCs or S corps.
● Use of Losses to Offset Future Business Income. If a C corp generates net operating losses rather than net income, these are carried forward to offset future corporate taxable income. However, such operating losses may not be used to offset taxable income of the individual shareholders.
Corporate losses cannot be deducted by individual stockholders.
● Self-Employment Tax Savings. There are potential self employment tax savings over what would be possible, for example, with an LLC. C corp shareholders are only subject to employment tax on reasonable salary amounts and not dividends.
● Taxed Distributions of Appreciated Property. A C corp’s distribution of appreciated property to its shareholders results in the recognition of gain by the C corp on the appreciation, which gain then flows or passes through to the C corp’s stockholders.
● Tax-Free Reorganizations. S corps, just like C corps, can participate in tax-free reorganizations (such as a stock swap) under IRC Section 368.
LLCs. If properly structured there is no tax at the entity level. Income/loss is passed through to members of the LLC.
● Flow Through Tax Treatment. LLCs are flow through entities for tax purposes, meaning that taxable income earned by the entity is passed through to individual members. Thus, earnings are taxed only once, at the member level.
● Tax Structure Flexibility. An LLC may elect to be taxed as a C corp, an S corp, or a partnership. It may specially allocate items of income or loss among its various members.
● Use of Losses to Offset Future Personal Income. Taxable losses generated at the entity level may be used to offset taxable income of the individual LLC members. However, such flexibility is countered by increased compliance costs due to the application of complex partnership tax rules that also apply to LLCs.
● Foreign Owners. LLCs may have to remit tax payments to the IRS on allocations to foreign owners. See IRC Code Section 1446.
● Self-Employment Tax Applies. LLC members are generally subject to self-employment tax on their entire distributive share of the LLC’s ordinary trade or business income.
● Tax-Free Distributions of Appreciated Property. An LLC can distribute appreciated property (e.g., real estate or stock) to its members without gain recognition to the entity or its members, facilitating spin-off transactions.
● Tax-Free Formation. Appreciated property can be contributed tax-free to LLCs under the IRC, whereas contributions of appreciated property to S corps in exchange for stock must comply with more restrictive provisions of the IRC to be tax-free (i.e., IRC Section 351).
● Taxed Reorganizations. LLCs with multiple members taxed as partnerships cannot participate in a tax-free reorganization under IRC Section 368. (This is a significant reason not to choose the LLC format if a stock swap is an anticipated exit strategy for your entity).
S Corps. No tax at entity level. Income/loss is passed through to the shareholders
● Flow Through Tax Treatment. Similar to LLCs, S corps receive flow through tax treatment.
● Income Allocated Pro-Rata to Stockholders. An S corp must allocate its taxable income to the individual stockholders according to their ownership stakes in the company. Taxable losses at the entity level may be used to offset personal taxable income of the individual stockholders, but only to the extent of the tax basis of their interests in the entity.
● Self-Employment Tax Savings. An S corp structure may result in the reduction in the overall employment tax burden. S corp shareholders are only subject to employment tax on reasonable salary amounts and not dividends.
● Losses Pass Through to Stockholder(s). The general rule is that losses generated by the S Corp pass through to the stockholder(s) of the S Corp. S corp losses can only be used to offset personal income up to the stockholders’ basis in the S corp stock.
● Taxed Distributions of Appreciated Property. An S corp’s distribution of appreciated property to its shareholders results in the recognition of gain by the S corp on the appreciation, which gain then flows or passes through to the S corp’s stockholders.