“Partnership” Taxation
Colorado LLCs and LLPs and domestic S-Corporations are pass-through entities and pay no taxes at the entity level. This is arguably the biggest advantage of forming an LLC or S Corporation, although not as big an advantage as many would believe (see, Phantom Income, below). The partnership tax classification allows the owners great flexibility in in allocating income, gains, deductions, losses and credits.
C-corporations are taxed once at the entity level and again at the individual shareholder level. C-corporations only pay taxes on profits. Thus, if the corporation has no profits, it pays no taxes. This issue is often relevant to new companies which seek substantial capital contributions but do not project to become profitable for several years. Shareholder income is taxed at his or her individual tax rate or at the lower capital gains rate if the stock was held for more than one year. Under the so-called American Taxpayer Relief Act of 2012, the top marginal tax rate on income was raised to 39.6% while the top capital gains rate went up to 20%.
S-Corp Election
Not all corporations may become S-corporations: (1) the entity must be a domestic corporation (i.e. organized under the law of the United States or of any State); (2) it may have only 100 shareholders; (3) none of the shareholders may be partnerships, other corporations, or non-resident aliens; and (4) the corporation may have only one class of stock, although not all shareholders need to have the same voting rights. Certain financial institutions, insurance companies and domestic international sales corporations are also ineligible for S-corporation status.
Phantom Income
Shareholders of corporations are only taxed if they actually receive dividends that year. However, members of an LLC are taxed every year on their share of profits in the LLC (as reported in their K-1 statement) whether or not they actually receive any income. This is known as “phantom income” and is, arguably, the biggest argument against the use of an LLC entity. While payment of annual taxes on this LLC “distributive interest” cannot be avoided, the Operating Agreement can, and should, provide that the LLC will distribute enough cash to pay the maximum potential tax liability of the members each year.
Self-Employment Tax
Shareholders of a corporation are not required to pay the 15.3% self-employment tax on any distributions. To the extent that a shareholder can increase his or her dividends or decrease wages he or she will receive a tax benefit. By contrast, active LLC members are required to pay self-employment taxes on their entire share in the LLC. Inactive LLC members may be able to avoid paying the self-employment tax but are strongly encouraged to consult a tax advisor.
Single-member LLCs are disregarded entities.
Fringe Benefits
Members in non-corporate entities, such as LLCs, LLPs, are now generally eligible to participate in qualified retirement plans on the same level as employees in a corporation. However, members of LLCs and LLPs are generally not eligible for as many tax-free fringe benefits as employees of corporations.
Taxation When the Business is Sold
In general, C corporations are the most favorable from a tax perspective if the owner anticipates that the lion’s share of his or her profit is likely to come from the sale of the business rather than from distributions of retained earnings (profits from operations). S corporations are not suitable targets for venture capital funds because S corporations are restricted to one type of stock. This prevents venture capital groups from securing their interests with preferred stock and employing other standard means of financing to maximize ROI.
If you are choosing between and S corporation and an LLC, the choice of entity is somewhat less clear. S corporations have certain advantages: first, shareholders of an S corporation may exchange their stock for stock in the acquiring entity without incurring tax liability (“reorganization”); second, shareholders of an S corporation (but not an LLC) may avoid gains on exit by structuring the deal as a stock sale rather than an asset sale; third, distributions to S corporation shareholders are not subject to self-employment taxes, but an LLC’s owner must generally pay self-employment taxes on his or her full share of the exit proceeds. Finally, S corporation shareholders, but not LLC members, may be eligible for local property tax exemptions on inventory, machinery or other personal property.
LLCs have their own advantages when compared to S corporations: first, if the company cannot qualify as an S corporation, an LLC provides for pass-through taxation; second, LLCs may be able to distribute appreciated assets or purchase members’ interests without tax effects due to the ability to write of tax bases in cases where an S corporation could not do so; third, LLC members may include losses from LLC debts even if they are not personally liable for the debt (subject to at-risk and passive loss limitations); finally, if the owners eventually convert the LLC to a C corporation, up to 50% of their stock in the new corporation may be tax-advantaged “small business stock.”
Contact Denver Business Lawyers for assistance.