What is a Corporation?
A corporation is a separate and distinct legal entity. This means that a corporation can open a bank account, own property and do business, all under its own name. The primary advantage of a corporation is that its owners, known as stockholders or shareholders, are not personally liable for the debts and liabilities of the corporation. For example, if a corporation gets sued and is forced into bankruptcy, the owners will not be required to pay the debt with their own money. If the assets of the corporation are not enough to cover the debts, the creditors cannot go after the stockholders, directors or officers of the corporation to recover any shortfall.
A corporation is managed by a board of directors, which is responsible for making major business decisions and overseeing the general affairs of the corporation. Like representatives in Congress, directors are elected by the stockholders of the corporation. Officers, who run the day-to-day operations of the corporation, are appointed by the directors.
One major disadvantage of a traditional corporation is double taxation. A traditional corporation, known as a C-corporation, pays a corporate tax on its corporate income (the first tax). Then, when the C-corporation distributes profits to its stockholders, the stockholders pay income tax on those dividends (the second tax). Therefore, tax is paid twice on the same income.
To avoid double taxation, corporations can make a special S-election to be taxed only once on the shareholders personal tax returns. Corporations that make this tax election are known as S-corporations. Why wouldn't every corporation make this valuable election? Not every corporation can qualify.
In general, the "C-Corporation" designation merely refers to a standard, general-for-profit, state-formed corporation. The "C" comes from subchapter C of the Internal Revenue Code which controls the method of taxing profits and operations.
Generally, the C-corporation is taxed on its own profits; then, any profits paid out in the form of dividends are taxed again to the recipient as dividend income at the individual shareholder's tax rate. This creates a "double tax" on the same income.
Tax Planning a Must
With proper tax planning, most small corporations avoid paying dividends. Rather, owner-employees are paid salaries and fringe benefits that are deductible to the corporation. The result eliminates the corporate level profit, but does not eliminate self-employment taxes which can be substantial
Annual Tax Filings
The C-corporation files its own annual corporate tax forms each year using IRS form 1120. Requisite state forms may also be required.
Limited Liability Company - LLC
Like a corporation, an LLC is a separate and distinct legal entity. This means that an LLC can obtain a tax identification number, open a bank account and do business, all under its own name. The existence of an LLC begins upon the filing of the Articles of Organization with the Secretary of State. The articles must be on the form prescribed by the Secretary of State.
In an LLC, its owners, known as members, are not personally liable for the debts and liabilities of the LLC. For example, if an LLC loses a big lawsuit and is forced into bankruptcy, the members will not be required to make up the difference with their own money.
An LLC can be taxed either as a "pass-through" entity like a partnership, or sole-proprietorship, or as a corporation. If an LLC chooses to be taxed as a pass-through entity (and most do), the owners of the LLC are not subject to double taxation. This is as opposed to a regular C-Corporation, which pays a corporate tax on its net income (the first tax) and then a second tax when the corporation distributes profits, as the stockholders pay income tax on dividends.
Self-Employment/Social Security Taxes
In an LLC, social security and Medicare taxes of approximately 15% are levied on profits to its active members. This can be a significant tax and thus the LLC may be considered too expensive tax wise as compared to other entity choices.
Separate Legal Entity
Like limited partnerships and corporations, an LLC is recognized as a separate legal entity from its "members."
Management and Control
Management and Control of an LLC is vested with its members unless the articles of organization provide otherwise.
An LLC may specially allocate profits or losses in a different ratio than the members' interest in profits, unless the articles of organization or operating agreement provide otherwise. This may be a big tax advantage to LLCs where members contribute different amounts.
To validly complete the formation of the LLC, members must enter into an Operating Agreement. This Operating Agreement may come into existence either before or after the filing of the Articles of Organization.
Annual Tax Filings
An LLC files its own annual tax forms each year depending on how the LLC is treated for tax purposes. Typically the LLC may file IRS forms 1065, 1120, 1120S, or schedule C. Requisite state forms may also be required.
The S-Corporation follows the same state formalities as does a C-corporation (i.e. filing Articles of Incorporation and paying state fees). However, an S-Corporation must make a special tax election using IRS Form 2553. The “S” comes from subchapter S of the Internal Revenue Code which controls the method of taxing profits and operations.
No Double Taxation
A traditional corporation, known as a C-corporation, is taxed as a separate entity, leading to double taxation. An S-corporation, on the other hand, is a corporation that elects to be treated as a pass-through for tax purposes. S-corporations are thus not subject to double taxation. Therefore, a shareholder's individual tax returns will report the income or loss generated by an S corporation. Moreover, the accounting for an S-corporation is generally easier than for a C-corporation.
Self-Employment Tax Savings
In an S-corporation, profits are treated as dividends to the owner and are thus considered unearned income and not subject to self-employment taxes. This can be a significant savings as self-employment taxes are approximately 15% and can add thousands of dollars to your tax bill. Only earnings actually paid out to an owner as compensation for services are subject to self-employment taxes.
Some Restrictions Placed on S-Corporations
- The S-corporation must not have more than 100 stockholders.
- Each stockholder must be an individual who is a citizen or resident of the United States, or an estate or qualifying trust of such person.
- The corporation must maintain a single class of stock.
- The corporation must generally use the calendar year as its fiscal year.
Electing to Be an S-Corporation
A new corporation wishing to become an S-corporation must file form 2553 with the IRS and may also need to file with the State. These forms generally must be filed no later than 75 days after the corporation has began conducting business as a corporation, acquired assets, or has issued stock to shareholders (whichever is earlier). An existing corporation which desires to become an S corporation must make it’s election by March 15 if the corporation is a calendar year taxpayer in order for the election to take effect for the current tax year.
Annual Tax Filings
The S-corporation files its own annual corporate tax forms each year using IRS form 1120S. Requisite state forms may also be required.
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