Corporations vs. LLCs

How do you know whether a corporation or LLC is right for your business?

Let's assume that you've concluded it would be advantageous to operate your small business through an entity that limits the personal liability of all the owners -- even if following this strategy involves a bit more paperwork, complexity and possible expense. You have two main choices -- either the tried and true corporation or the new and streamlined limited liability company (LLC). Which is better? There's no answer to this question that applies to every business. Nevertheless, some general principles may be helpful.

When an LLC May Make Sense

For the majority of small businesses, the relative simplicity and flexibility of the LLC makes it the better choice. This is especially true if your business will hold property, such as real estate, that's likely to increase in value. That's because regular corporations (sometimes called C corporations) and their shareholders are subject to a double tax (both the corporation and the shareholders are taxed) on the increased value of the property when the property is sold or the corporation is liquidated. By contrast, LLC owners (called members) avoid this double taxation because the business's tax liabilities are passed through to them; the LLC itself does not pay a tax on its income.

When a Corporation May Make Sense

An LLC isn't always the best choice, however. Occasionally, other factors will be present that may tip the balance toward a corporation. Such factors include the following:

• You expect to have multiple investors in your business or to raise money from the public. While an LLC works fine when you have just a few investors -- especially those who will be active in the day-to-day operations of the business -- it may get more awkward when the number of investors increases. For example, you'll likely run into resistance from potential investors if you can't offer them the corporate stock certificates that they consider tangible evidence of their partial ownership of the business. Rather than wasting your time trying to overcome this resistance, it's probably better to structure your business as a corporation.
• You'd like to provide extensive fringe benefits to owners. Often, when you form a corporation, you expect to be both a shareholder (owner) and an employee. The corporation can, for example, hire you to serve as its chief executive officer, pay you a tax-deductible salary, and provide fringe benefits as well. These benefits can include the payment of health insurance premiums and direct reimbursement of medical expenses.

The corporation can deduct the cost of these benefits and they are not treated as taxable income to the employees, which can be an attractive feature of doing business through a regular corporation. With an LLC, you can only deduct a portion of medical insurance premium payments, and other fringe benefits provided to members do not receive as favorable tax treatment.

• You want to entice or keep key employees by offering stock options and stock bonus incentives. Simply put, LLCs don't have stock; corporations do. While it's possible to reward an employee by offering a membership interest in an LLC, the process is awkward and likely to be less attractive to employees. Therefore, if you plan to offer ownership in your business as an employee incentive, it makes sense to incorporate rather than form an LLC.

When an S Corporation May Make Sense

Self-employment taxes can tip the balance toward S corporations, since LLC owners may pay more. What are self-employment taxes? Well, you know that taxes are withheld from employees' paychecks. In 2005, employers must withhold 7.65% of the first $90,000 of an employee's pay for Social Security and Medicare taxes, and 1.45% of earnings above that amount for Medicare taxes alone. The employer adds an equal amount and sends these funds to the IRS. (The total sent to the IRS is 15.3% on the first $90,000 of wages and 2.9% on anything above that.) You may not be aware that the IRS collects a similar 15.3% tax on the first $90,000 earned by a self-employed person and a 2.9% tax on earnings above that amount. This is the self-employment tax.

For an S corporation, the rules on the self-employment tax are well established: as an S corporation shareholder, you pay the self-employment tax on money you receive as compensation for services, but not on profits that automatically pass through to you as a shareholder. For example, if your share of S corporation income is $100,000 in 2005 and you perform services for the corporation reasonably worth $65,000, you will owe the 15.3% self-employment tax on the $65,000 but not on the remaining $35,000.

By contrast, the self-employment tax may be imposed on an LLC owner's entire share of LLC profits. However, the rules for members of an LLC are murky.

Proposed IRS regulations (which Congress has placed on indefinite hold) would impose the self-employment tax on an LLC owner's entire share of LLC profits in any of the following situations:

• The LLC owner participates in the business for more than 500 hours during the LLC's tax year.
• The LLC provides professional services in the fields of health, law, engineering, architecture, accounting, actuarial science or consulting (no matter how many hours the owner works).
• The LLC owner is empowered to sign contracts on behalf of the LLC.

Until the IRS clarifies the rules on self-employment tax for members of an LLC, you should assume that 100% of an LLC member's earnings will be subject to the tax.

Therefore, an S corporation shareholder may pay less self-employment tax than an LLC member with similar income. You'll need to decide if this potential tax saving is enough to offset such LLC advantages as less formal record keeping and flexibility in management structure and in the method of distributing profits and losses.