I am tempted to say “in the beginning” … However, some context is useful. Fundamentally there are three forms of business entities. A Sole Proprietor(ship), a Partnership, and lastly Corporation. I suspect they were developed in that order. Everything else stems from those three forms. In determining which form is good for you is a combination of tax structure and which legal form works best for you. You should consult with you CPA and Attorney to determine which way to go.
In a Sole Proprietorship, you, the owner, are the business. All liabilities are your responsibility personally. That includes both financial and legal (e.g. trip and fall, product liability etc.). All income and expenses are filed on the form 1040 Schedule C and the Profit or Loss (line 31) go on your 1040 line 3. There is no double taxation, as there would be with a Corporation sometimes also referred to as a “C” corp. While we will get to it latter, a corporation pays taxes on the profit it makes and distributes to you are taxable on your personnel income tax filing (1040).
A Partnership is similar to a Sole Proprietorship in that you get taxed on your portion of income of the business. However, your responsibility for liability is usually on the total liability of the company both financial and legal. It should be noted that Limited Partnerships (LP) can typically restrict that liability. I am not going to discuss here either LP’s or Limited Liability Partnerships (LLP).
Generally speaking, in the first two forms the owners operate the business. Typically, an active participation. However, in a partnership the control, investment, ownership and distribution of earnings do not have to be equal or related to the amount invested. A simple example of what this means is that one partner, could put in all the money (investment) and not have anything to do with it the operation of the business, while the other partner operates the business and receives a disproportionate share of the profits. As a side note sometimes the value of the work put in by the non-cash investing partner is called “sweat equity”. As you can see from the simple example, partnerships can allow for a lot of structural flexibility. When it comes to Taxes, the partnership files a form 1065. It is called an informational return as it informs the IRS how income is allocated between the owners. The owners receive a K-1 which they then report on their taxes.
The last of the three primary business structures is a Corporation. It differs from the first two in some fundamental ways.
- The ownership interested is represent by shares of Stock (a stock certificate). The more shares you own the more of an ownership interest you have and generally the more control over the business you can exercise.
- Share owners or Stockholders do not have to work in the business. Their investment can be totally passive.
- Shareholders who work in the business are paid a salary and are employees and their income is subject to ordinary income tax and social security (other related taxes).
- As I indicated earlier, profits of the business are subject to federal taxation and then what is distributed is subject to personal income tax.
- Distribution of profits (not salary) must be proportionate to the number of shares owned. No uneven distributions, as is possible in a partnership.
- Some consider the biggest difference is that Liability in all forms stays with the business and as a rule does not transfer to the individual owners. However, your investment in the business can be lost
Why the need for other business forms?
Each of the three forms of business presented suffers from some structural flaws.
- Some have double taxation,
- Some have distribution of profit issues, and others
- Unlimited liability issues.
Sub(chapter) S Corporations or S Corporations
To solve many of the problems, the concept of a S Corp was developed. Technically, I would say there is no such thing as a “S Corp”. When you go to create a corporation, which is easily done on SunBiz.Org (for the State of FL), there is only one type of legal corporation. So, what is a S Corp or sometimes called a Sub S? It is a creation of the US tax code. Congress recognized that most small business corporations are really created to give the owners’ liability protection. These corporation were otherwise more akin to sole proprietorships or partnerships. Thus, to reduce the tax burden cause by this, the concept of an S Corp was developed. It should be noted that regular corporations are sometimes referred to as “C Corp’s”.
To quote from the IRS website:
“S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.
To qualify for S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).”
The Age of the LLC
The S Corp solved some big problems but still lacked the flexibility of a Partnership. Simple examples are “sweat equity”, unequal distribution of profits (or losses for that matter), ownership and operational control can be structured, can be either passive or active investment.
An LLC. unlike an “S Corp”, is created or governed by State Law. While they may be simple to create as is possible for Florida on sunbiz.org. They are very nuanced and should be created with the aid of both legal and Tax professional.
To quote from the IRS website:
“Owners of an LLC are called members. Most states do not restrict ownership, so members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single-member” LLCs, those having only one owner.
A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state’s requirements and the federal tax regulations for further information. There are special rules for foreign LLCs.
Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”). Specifically, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation. For income tax purposes, an LLC with only one member is treated as an entity disregarded as separate from its owner, unless it files Form 8832 and elects to be treated as a corporation. However, for purposes of employment tax and certain excise taxes, an LLC with only one member is still considered a separate entity.”
LLC – a deeper dive
It is not that an LLC member has no risk, it is that an LLC member’s risk is also limited to the loss of their investment. More importantly, depending on state law, the ownership interest in an LLC is considerably more creditor protected than are shares in an S corporation which are easily seized by a stockholder’s creditors. A member’s interest in an LLC is creditor protected in the same way a partnership interest in a limited partnership is protected. A member’s personal creditor is limited only to a charging order against the LLC interest, which gives the creditor only the right to receive distributed profits due the debtor partners.
The other advantage of an LLC over an S corporation is that the LLC affords you more ownership options. For example, your LLC can be owned by anyone or any entity including a family limited partnership (FLP), a trust, another corporation, etc. S corporation shares cannot be owned by these entities. Their stock ownership is restricted to individuals or specialized trusts. Thus, it is much more difficult to protect an S corporation than it is an LLC. Another advantage of the LLC is that you can integrate your Estate Planning. As discussed earlier, there are other structural advantages to an LLC.
There are still a few advantages of an S corporation over an LLC: (1) S corporation owners pay employment taxes only on their salaries, while LLC owners pay employment taxes on all profits; and (2) State taxes may be lower for an S corporation.
(information in the previous section is based on information from “The Presser Law Firm, P.A.” (561) 953-1050 or e-mail Info@AssetProtectionAttorneys.com)
The following section is extracted from: “LLC vs S Corporation.” Diffen.com. Diffen LLC, n.d. Web. 26 Feb 2020. https://www.diffen.com/difference/LLC_vs_S_Corporation
LLC members filing returns as individuals and shareholders of an S corporation are both subject to the same marginal tax rate of 39.6%. We also know that the standard C corporation is taxed at the rate of 35%, significantly lower than LLC or S corporation rate. Thus, it would be beneficial to have in place as a member a C corporation that is taxed at its marginal rate versus an individual member taxed at the higher individual rate.
Another distinction arises when discussing the payment for services rendered with membership interests or stock. If a potential member of an LLC is paid for services rendered in the form of membership shares, the transfer is treated as guaranteed interest and thus gross income and subjects the payment to taxation at the fair market value of the shares. This taxation can be circumvented if the new member immediately makes a capital contribution or transfers assets to the LLC. If in cash form, the amount can be as little as $500 contributed.
In comparison, a corporation is treated substantially different. When stock in a corporation is received in exchange for services or products rendered, this stock is fully taxable, with the exception of transferable or forfeitable stock.
Accounting Method – Cash or Accrual Basis?
As a rule, LLCs are not permitted to use the cash or modified-cash basis accounting system, and must adopt the accrual basis accounting method, with very few exceptions. These exceptions are limited to an LLC who did not generate losses, or one in which the members are professionals that practice in the same area that the LLC operates in.
The S corporation, however, can elect either the accrual method or cash/modified cash basis accounting methods, with the usual obvious business necessities observed.
In an LLC, certain distributions, such as appreciated property, are not treated as gains or losses and hence free from taxation.
In an S corporation where no profit is realized but a distribution made to a shareholder, the distribution is treated as return of capital and not subjected to taxation
Which Organization Method is Best for my Company? Should I Organize my Enterprise as an S Corporation or an LLC?
If you intend for your corporation to have more than a few shareholders (but less than 75) and you can appreciate the benefits of pass-through taxation while at the same time understanding the potential pitfalls involved with the “taxation irrespective of distribution,” and you meet the legal requirements outlined above, then the S corporation can go a long way towards making your business profitable and attractive to the right investors.
However, there certainly are very quantifiable benefits to forming as an LLC rather than an S corporation. For example, while a Sub-chapter “S” corporation may allow for many of the same protections and asset distribution facilities, it is limited to between 75 and 100 shareholders, and none of these shareholders can be in the form of a Corporation or IRA’s (in direct contrast to an LLC which does permit corporations as “Members”)–thus limiting the “S” option to smaller organizations or forcing the buyback or buyout of stockholders for those organizations wishing to convert. Further, with the guaranteed operating and management flexibility afforded by the Operating Agreement, and the freedom from the very stringent rules and procedures imposed by the necessity of the corporate formalities that accompany an S corporation, the LLC can be the more attractive option in most cases.