What’s in a name?

What’s in a name? If you’re choosing a corporate entity structure, designating your company as an LLC, S-corp or C-corp could change
the way you pay taxes, split annual income and divide the profit from a business sale. Deciding which structure fits your company is confusing — especially when everyone seems to offer advice on the “best” (and presumably least taxing) option.

“Business owners hear talk out there about the latest fad and figure the best thing for their peers will also work for their businesses,”
says Bruce Friedman, a director for SS&G Financial Services Inc. “Setting up an entity without having all the information is a mistake.”

Smart Business asked Friedman for more information to help you make an educated decision.

What are some characteristics of an LLC structure?

LLC stands for limited liability company, and it is the most flexible of all three entities. It has the legal aspects of a corporation but the
tax characteristics of a partnership. In other words, LLCs are protected by the corporate veil from a legal perspective, but they are subject to self-employment tax.

LLC owners are called members. There is unlimited ownership — an LLC can have members that are single shareholders or corporations. Also, ownership does not have to be consistent with profit sharing. When splitting profits, you have the ability to be extremely creative. You can give preferred investors higher returns. For example, if an LLC includes two members that own the LLC 50/50, they can
split annual income 70/30. And if they decide to sell the business, they do not have to split the profits according to this same proportion.
They can choose to sell and split it 50/50. The key is, ownership must account for these arrangements in an operating agreement.

What might deter a company from choosing an LLC structure?

LLCs are complex and require an operating agreement that explains how members will share profit, sell the company, etc. This entity can be much more costly to administer than, say, an S-corporation. And because members of an LLC are subject to self-employment taxes, LLCs are generally more taxing than S-corps, as well.

Why might a company choose an S-corp instead of an LLC? What benefits does S-corp entity structure provide?

The S-corp is similar to an LLC, but it’s much less flexible. You are limited in the number of shareholders, and you must share profits
based on the ownership distribution. In other words, if two shareholders own equal parts of the company, they must always split the
profits 50/50. But S-corps are less taxing than LLCs. Shareholder salaries are subject to Social Security and Medicare tax, but residual
profits are not subject to self-employment taxes.

If a company does not need flexibility in profit sharing and does not expect to require this flexibility down the road, I generally recommend a less taxing S-corp structure that is easier and less expensive to administer.

What are examples of typical LLC and S-corp entities?

Rental companies are often LLCs, and sole proprietors can be single-member LLCs. This is a disregarded entity by the federal government,
so the sole proprietor does not have to file a separate entity tax return. Tax information is filed on the personal income tax schedule and,
basically, the single-member LLC is taxed no differently than before. The advantage is that this sole proprietor gets a corporate veil and can
protect personal assets in case of legal action.

However, I find that S-corps are ideal for many companies. I often recommend this entity structure because it fits most companies’
requirements and is a low-maintenance, tax-beneficial option.

What about C-corps? What type of company would adopt this entity structure?

C-corps are dinosaurs, mainly because of double taxation. Any profits in the business are taxed at the corporate level, and shareholders must also pay taxes on the income they take from the business. For example, if a C-corp gains $5 million, it pays the highest tax rate,
which is about 42 percent. Then, from that, the shareholder must pay tax again on whatever is left. In our example, after paying the initial business tax, a C-corp is left with $2.9 million. Then, it must take that money out of the business and pay another 20 percent in taxes.
The take-home is $2.3 million. If this company were an S-corp, the $2.9 million would be the company’s (and shareholders) to keep.

When is a C-corp appropriate?

All public companies are C-corps. First, C-corps are not limited in number of shareholders. Also, for owners with multiple entities, we
might set up one of the businesses as a C-corp to take advantage of lower income tax rates on some income.

BRUCE FRIEDMAN is a director at SS&G Financial Services Inc. Reach him at [email protected] or (330) 668-9696.