Confused about LLC vs. corporation taxes? Taxes are unavoidable as a business owner, and you'll need to pay taxes one way or another regardless of your company's structure. Each structure has its own benefits, however, so the one you choose could affect your business's tax burden more than you may think.

What Does It Mean to Incorporate?

Incorporating a business takes it from a sole proprietorship or a general partnership to a company formally recognized as a legal entity separate from its founders. When this occurs, your company's structure will fall into one of these categories:

  • Limited liability company (LLC)
  • Corporation (Corp.).

Corporations are further subdivided into S corporations (S corps) and C corporations (C corps).

Regardless of how you choose to incorporate your business, your company will enjoy certain advantages, such as increased credibility and liability protections. Of course, there are also disadvantages worth noting about each incorporation structure.

No, An LLC is Not a Corporation

An LLC is a limited liability company, not a corporation. As such, an LLC is registered with the state, but it doesn't actually "incorporate."

For tax purposes, the IRS recognizes two types of businesses:

  • Pass-through entities
  • Separate business entities.

Pass-through businesses are those in which finances are passed through to the owners. Therefore, the business income is declared as the owner's income on his or her personal tax return. Limited liability companies are considered pass-through entities.

Corporations, on the other hand, are separate entities. A corporation's finances are taxable to the corporation, not the shareholders.

LLCs haven't been around as long as corporations, but they are now the most popular business structure by a wide margin. In addition to being a pass-through tax entity, an LLC enjoys less paperwork than corporations.

In a single-member LLC, the income earned by the company passes on to that member, who then reports it as his or her personal income. In a multi-member LLC, the business is taxed like a partnership. Each member receives a K-1 report detailing which portion of the losses and gains are his or hers. They can then use this information to file their own 1040.

One drawback, however, is that LLC members are subject to self-employment Medicare and Social Security tax, which is why some LLCs choose to elect S corp status.

C Corp Versus S Corp

Before you start a corporation, consider the differences in C corp and S corp status. C corporations are your typical corporate structure. If you file your articles of incorporation and do not register an S corp, your company is a C corp by default.

Owning a C corp will allow you to:

  • Separate your personal and business finances, including debts.
  • Enjoy protection against lawsuits.
  • Sell shares to raise capital.

When you establish a corporation, you're creating a separate legal entity capable of earning its own income. Most states collect tax on corporate income, and corporations are subject to double taxation. This double taxation comes from the corporate tax itself and the fact that owners must pay personal income taxes on the wages they earn from operating the business.

One way smaller corporations can avoid double taxation is by choosing S corp status.

S corporations are taxed according to the Internal Revenue Code's Subchapter S, hence the name. Having S corp status allows the company to enjoy pass-through taxation, where income flows through the corporation directly to the shareholders, who then report the finances on their personal tax returns. Essentially, an S corp is taxed more like a partnership or an LLC.

There are a few catches, though. For starters, only smaller corporations can elect S corp status. Your corporation cannot have more than 100 shareholders or issue more than one class of stock. You must also elect S corp status no later than the 15 day of the third month of the tax year; otherwise, the business will be treated as a C corp.

Some states also impose tax on S corp income. California, for instance, imposes a 1.5 percent tax on net income.

How to Decide Between an LLC or a Corporation

Take plenty of time to evaluate your options before deciding between an LLC or a corporation. You may also want to get professional advice from a tax accountant with experience in small-business taxation. Consulting an attorney knowledgeable in LLCs and corporations is also advisable.

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