Your Guide To SMLLCs, S corps, C corps & Partnerships

Learn all about the benefits and tax implications of different business entities

Table of Contents

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SMLLC Taxes

A single-member limited liability company (SMLLC) pays taxes just like every other individual taxpayer according to the individual income tax rates published by the Internal Revenue Service. The current tax rates range from 10% to 37%. Here are the tax rates that will apply when filing your 2021 tax return by the April 2022 tax deadline:

Here are the tax rates if you are single:

[insert table]

Here are the tax rates if you are married:

[insert table]

Tax rates if you’re a single parent:

[insert table]

Tax rates if you’re married but separated:

[insert table]

EXAMPLE: You’re a single taxpayer who has taxable income of $75,000 that you’ll report on your 2021 individual tax return. Here’s how to calculate the income tax you’ll owe:

  1. Locate the appropriate tax table for single taxpayers.
  2. Your income of $75,000 falls on the third line of the table, which states to multiply the amount of your income that exceeds $40,525 by 22%, then add $4,664.00.
  • Step one: ($75,000-$40,525) = $34,475 x 22% = $7,584.50
  • Step two: $7,584.50 + $4,664.00 = $12,248.50

Your total tax income tax liability is $12,248.50.

But wait, there’s more…

Self-employment taxes

The previous section explained how an SMLLC pays INCOME TAXES. An SMLLC also has to pay SELF-EMPLOYMENT TAXES (SE Taxes). So how is SE taxes different than income taxes? SE taxes are specifically earmarked to pay for Social Security and Medicare, so you’ll sometimes hear “SE taxes” also referred to as Social Security taxes or Medicare taxes.

For SMLLC’s, the SE tax rate is between 14% and 15%. (If you’d really like to know why we said “approximate,” we’d be happy to elaborate!). Let’s continue our example from above. Of the $75,000 in the taxable income you reported on your tax return, $15,000 was from your spouse’s paycheck, while the remaining $60,000 was the net profit from your business.

After going through the SE tax calculation from the IRS, your total SE tax liability is $8,477.

Total tax liability for you as an SMLLC

Your grand total tax liability in this example is the combination of the $12,248.50 in income taxes plus the $8,477 in self-employment taxes, or $20,725.50.

Does a single-member LLC need to pay quarterly taxes?

A single-member LLC (SMLLC) is generally required to make estimated tax payments, as taxes must be paid as you earn or receive income throughout the year, either through withholding or estimated tax payments. Estimated tax payments are used to pay not only income tax but also other taxes such as self-employment tax and alternative minimum tax.

Deadline to pay your estimated taxes

For estimated tax purposes, your tax year is divided into four payments periods:

  • 1st Payment Deadline: April 15th – Covers income earned from January 1 to March 31
  • 2nd Payment Deadline: June 15th – Covers income earned from April 1 to May 31
  • 3rd Payment Deadline: September 15th – Covers income earned from June 1 to August 31
  • 4th Payment Deadline: January 15th – Covers income earned from September 1 to December 31

NOTE: If the payment deadline falls on a weekend or legal holiday (i.e. Martin Luther King, Jr. Day in January and Washington D.C.’s Emancipation Day in April), you may wait until the following business day to mail or submit your payment.

How to calculate your estimated taxes

Here are some suggestions for figuring out how much your estimated tax should be.

  • A good starting point is to use your income, deductions, and credits on your prior-year tax return.
  • Next, estimate your expected adjusted gross income, taxable income, taxes, deductions, and credit for the entire tax year.
  • Use the worksheet provided by the IRS in the instructions to Form 1040-ES or call our office for assistance.

If you subsequently discover that your estimate was too high, simply complete another Form 1040-ES worksheet to recalculate your estimated tax when it comes time for your next payment. If your estimate was too low, complete another Form 1040-ES worksheet to adjust your next payment.

How to pay your estimated taxes

You can send estimated tax payments with Form 1040-ES by mail, or you can pay online, by phone, or from your mobile device using the IRS2Go app. You can pay your estimated taxes weekly, bi-weekly, monthly, etc. as long as you’ve paid enough in by the end of the quarter.

Avoid paying a penalty!

If you don’t pay enough tax through withholding and estimated tax payments, you may be charged a penalty and/or interest. You may also be charged with a penalty if your estimated tax payments are late, even if you are due a refund when you file your tax return.

SMLLC tax return

An SMLLC owned by an individual (i.e., not owned by a corporation or a partnership) files its tax return on Form 1040, Schedule C. An individual owner of a single-member LLC that operates a trade or business is subject to the tax on net earnings from self-employment in the same manner as a sole proprietorship.

If the single-member LLC is owned by a corporation or partnership, the LLC should be reflected on its owner’s federal tax return as a division of the corporation or partnership.

This article will discuss a SMLLC filing a tax return as an individual on Form 1040, Schedule C. If you have an SMLLC owned by a corporation or partnership, please contact our office with any questions about how to file the SMLLC’s tax return.

How to fill out a Schedule C for your SMLLC

  • Keep accurate books. Completing a Schedule C starts with great year-round bookkeeping from your business. An accurate balance sheet and income statement helps to make preparing your tax return extremely easy every year. Another benefit of always having up-to-date books when tax time comes is you don’t run the risk of reporting too much (or too little!) income. Please call if you need help with setting up an accounting system for your SMLLC, or for ongoing assistance to keep your bookkeeping up-to-date.
  • Record your income. The first section of Schedule C is where your business’s income is recorded. On Page 2 of Schedule C is a worksheet if you have cost of goods sold. Calculate your cost of goods sold using this worksheet, then enter the total amount in the income section on Page 1.
  • Record your expenses. The second section of Schedule C is where your business’s expenses are recorded. If you have a home office, you can report your associated expenses (i.e. utilities, property taxes, internet, etc.) using one of two different methods. On Page 2 of Schedule C is where you enter the details for vehicle expenses and miscellaneous expenses that don’t have a home on Page 1.
  • Calculate your net profit or loss. Subtract your total expenses from your gross income to compute your net profit or loss.
  • Calculate your income and self-employment tax. Take your net profit or loss and enter it on to page 1 of your Form 1040 where you will calculate your income tax. Also enter your net profit or loss on Schedule SE, which is where you’ll calculate your self-employment tax. See the previous section on calculating both income and self-employment taxes.

S corporation

S corporation tax rate

An S corporation is considered a pass-through entity for tax purposes, which means that a shareholder’s share of income (or losses) from the S corporation is reported on that shareholder’s individual tax return.

Once the shareholder reports his or her income (or losses) on Form 1040, the shareholder pays taxes just like every other individual taxpayer according to the individual income tax rates published by the Internal Revenue Service. The current tax rates range from 10% to 37%. Here are the tax rates that will apply when filing your 2021 tax return by the April 2022 tax deadline:

Here are the tax rates if you are single:

[insert table]

Tax rates if you are married:

[insert table]

Tax rates if you’re a single parent:

[insert table]

Tax rates if you’re married but separated:

[insert table]

EXAMPLE: You’re a married taxpayer who has taxable income of $60,000 from an S corporation. Your spouse is also reporting W-2 income of $85,000. The total taxable income that you’ll report on your 2021 Form 1040 is $145,000. Here’s how to calculate the income tax you’ll owe:

  1. Locate the appropriate tax table for married taxpayers.
  2. Your income of $145,000 falls on the third line of the table, which says to multiply the amount of your income that exceeds $81,050 by 22%, then add $9,328.
  • Step one: ($145,000-$81,050) = $63,950 x 22% = $14,069
  • Step two: $14,069 + $9,328 = $23,397

Your total tax income tax liability is $23,397.

S corporation tax returns

So how does an S corporation shareholder find out exactly how much income (or losses) to report on their individual tax return?

S corporation tax benefits

Starting a business with the goal of “taking it public” or attracting institutional investors is the goal of many entrepreneurs.

Bootstrapping a business and trying to grow it as large as possible, with the goal of either staying on as the founder/CEO or eventually selling to another business, is another common goal of entrepreneurs.

A third objective for starting a business is aiming to sustain a particular level of income with as few employees as possible. These entrepreneurs don’t have the ambition to grow as big as possible and eventually sell. Their goal is to build a business to a specific income level that can sustain the founder’s preferred lifestyle. This is where the term “lifestyle business” comes from.

For many of these so-called lifestyle businesses, the S corporation entity is a perfect choice for a business entity. You may already be asking yourself how are S corporations both similar and different to C corporations? What makes an S corporation a good fit for a lifestyle business?

Where does an S corporation come from?

Both C corporations and S corporations are born the same way – by filing Articles of Incorporation with the state in which the business will be located. (A business organized as a limited liability company can also elect to be treated as an S corporation for tax purposes.)

(Remember that the terms “C corporation” and “S corporation” are tax terms, not legal terms.)

Once a business has incorporated, it can choose to be taxed either as a C corporation or S corporation.

If the business wants to be taxed as a C corporation, nothing further needs to be done. The default tax entity for an incorporated business is the C corporation.

If the business wants to be taxed as an S corporation, Form 2553 (“Election by a Small Business Corporation”) needs to be filled out and submitted to the IRS. Filling out Form 2553 and submitting it to the IRS is also referred to as “making an S-election.”

As with any other IRS form, there is a deadline to submit Form 2553. The general deadline to submit an S-election is the due date for the S corporation’s tax return. For an S corporation with a December 31 year-end, the deadline to submit both the tax return and S-election is March 15th.

A simple structure for simple businesses

If you wanted to start a business in the first half of the 20th century, you had two options:

  1. Form a C corporation to take advantage of liability protection but be subjected to two layers of federal tax at the corporate and individual level, or…
  2. Choose to be a sole proprietorship or partnership, enjoy the benefit of a single layer of taxation, but forgo the liability protection afforded C corporations.

Neither of these choices was favorable for small and family-owned businesses. In 1946, the Department of Treasury suggested the third choice of entity, one that combined the liability protection of a C corporation with the single layer of taxation from sole proprietorships or partnerships.

U.S. taxpayers waited another 12 years before this suggestion of a hybrid entity actually came to fruition. In 1958, Congress and President Dwight Eisenhower created Subchapter S of the tax code. Subchapter S provided the benefit of limited liability that C corporations have while maintaining the tax benefits of sole proprietorships and partnerships.

The S corporation was created to address the specific problems faced by small businesses looking to enter markets dominated and controlled by large corporations.

There were four trade-offs, however, to using the new S corporation entity structure:

  • Must be a domestic business
  • Have a limitation on the number of shareholders it is allowed to have
  • Have limitations on who could be a shareholder
  • Can only have one class of stock

For many small businesses in the mid-20th century, these limitations were often never an issue.

Former Internal Revenue Service commissioner Don Alexander described the S corporation as “a simple structure for simple people” and simple businesses during Congressional testimony in 2006.

Let’s take a closer look at each one of these limitations and how they affect businesses 60 years after the S corporation was written into law. 

S corporations: Must be a domestic business

When grappling with how to best help small businesses in the United States, the Internal Revenue Service, Congress and President Eisenhower recognized the need for a business entity that combined the limited liability of a C corporation and the simplicity of a sole proprietorship or partnership.

Our esteemed politicians also understood that a new, hybrid business entity could lead to all kinds of unintended consequences. (That’s how the U.S. tax code works, right? Congress passes a law, then CPAs and attorneys figure out different ways of legally working around the new law.)

To make sure that this new, hybrid entity would benefit only U.S. small businesses, the first limitation of an S corporation is that it must be a domestic business.

S corporations: Limitation on number of shareholders

When S corporations were first created in 1958, the maximum number of shareholders allowed was 10. The number of allowable shareholders slowly increased every few years. The American Jobs Creation Act of 2004 expanded the allowable number of shareholders to its current level of 100.

One of the reasons the number of allowable shareholders kept increasing was to accommodate family businesses that grew over multiple generations to include multiple family members. This problem was also addressed in 2004 when new rules allowed all members of a family (as defined by the tax code) to be treated as a single shareholder.

S corporations: Limitations on who can be a shareholder

Shareholders of an S corporation must be U.S. citizens or residents; non-resident aliens are not permitted to be a shareholder.

Shareholders must also be natural people; therefore corporations and partnerships are ineligible to be shareholders.

Certain trusts, estates, and tax-exempt corporations (including 501(c)(3) corporations) are eligible to be S corporation shareholders.

An S corporation can also be a shareholder in another subsidiary S corporation if the parent S corporation owns 100% of the stock of the subsidiary corporation. An election is made to treat the subsidiary S corporation as a “qualified subchapter S subsidiary.” Once the election is made, the subsidiary S corporation is not treated as a separate organization for tax purposes.

There have been ongoing discussions about this particular limitation and if changes should be made due to the global nature of today’s economy. When the S corporation was born in 1958, opportunities to be a nonresident alien shareholder were not that common, for example. But in today’s global economy, many businesses have employees as well as owners and investors located in multiple foreign jurisdictions.

While the limitation on who can be an S corporation shareholder will likely never completely go away, stay tuned to see what changes might be made in the future to accommodate the everchanging way that countries around the world conduct business.

S corporations: Can only have one class of stock

The Internal Revenue Service definition of a single class of stock means that all shares of stock outstanding must provide “identical rights to distribution and liquidation proceeds.”

Another way to interpret this definition is all profits and losses are allocated to shareholders proportionately to each shareholder’s interest in the corporation.

The effect of these limitations affect S corporations

These four limitations don’t affect 90% of S corporation businesses

So with these four stipulations on what an S corporation is allowed and not allowed to do, wouldn’t it be a headache to be an S corporation shareholder?

For sure, some businesses would have trouble avoiding these four limitations. But for the vast majority of businesses who elect to be taxed as an S corporation, these limitations rarely get in the way. And the statistics of S corporations back up this theory.

In 1995, there were 2,153,119 S corporation tax returns filed with the Internal Revenue Service. In 2003, the number of S corporations was approaching 3.5 million, an increase of 65% percent.

C corporation tax returns, on the other hand, decreased from 2.6 million in 1986 to 2 million in 2003.

Despite the extra hurdles S corporation shareholders need to jump through, the S corporation was a smashing hit with U.S. small business owners.

Here’s another statistic to consider – Close to 90% of S corporations have 3 or fewer shareholders: In 1995, 52% of S corporations had 1 shareholder; 30% had 2 shareholders; 7.6% had 3; 8.7% had 4 to 10. Only 1.6% of all S corporations had more than 10 shareholders. Average total assets for S corporations were $473,000, while C corporations averaged $10.8 million.

The vast majority of S corporations are truly small businesses run by a small number of shareholders. These businesses never encounter the 100 shareholder limit, have to deal with ineligible shareholders or multiple classes of stock. The S corporation is serving exactly who it was intended to serve: small businesses based in the United States.

Losing S corporation status

The S corporation is the only business entity where you can lose your entity tax status.

And it’s pretty simple to do it.

All a business has to do to lose its S corporation status is violate one of the four restrictions mentioned earlier in this article:

  1. Have more than 100 shareholders;
  2. Having the business be a foreign business;
  3. Have an ineligible person or entity as a shareholder; and
  4. Have more than one class of stock.

Shareholders must be vigilant in a business’s compliance with these limitations because these limitations can sometimes be inadvertently violated.

Ownership limitations make raising capital difficult

If you’re starting a business with the goal of raising capital or attracting investors at some point in the future, electing to be an S corporation could possibly hinder these efforts.

What happens if you have an angel investor from England who wants to provide your business with several hundred thousand dollars? What about a venture capital firm headquartered in Singapore wanting to invest in your business? You would have to turn down both these potential investors because the angel investor is a foreign alien, while the venture capital firm is a partnership. Both foreign aliens and partnerships are ineligible to be S corporation shareholders.

If you are fortunate enough to find angel investors who live in the U.S., many companies will require a number of different investors. The 100 shareholder limitation can fill up pretty quickly.

How are S corporations taxed?

In 2021, Jill started a dentistry practice. She is the sole owner.

After paying all her business’s expenses, Jill’s practice turned a profit of $100,000. Jill has to pay income taxes on the $100,000 profit on her Form 1040 tax return. If Jill’s income tax rate was 15%, she would have to pay $15,000 in income taxes.

If Jill’s business was a sole proprietorship, she would also have to pay self-employment taxes of 15.3% on the $100,000 profit, or $15,300. Jill’s total tax bill as a sole proprietor would be $15,000 of income taxes + $15,300 in self-employment taxes = $30,300.

If Jill’s business were an S corporation, she wouldn’t have to pay ANY self-employment taxes on the $100,000 profit. Jill would only have to pay income taxes on the $100,000, or $15,000.

Sounds like no contest, correct? S corporation wins? Why would you willingly choose to pay $30,300 in income and self-employment taxes if your business is a sole proprietorship vs. only $15,000 in income taxes if your business is an S corporation?

There must be a catch, right? Can S corporations really pay no self-employment taxes?

You bet there’s a catch. Shareholders must report reasonable compensation.

It’s true that Jill doesn’t have to pay self-employment taxes on the business’s $100,000 profit. The IRS, however, forces Jill to take a “reasonable salary” from the business.

In our example, Jill would be forced (by the IRS) to take a salary of approximately $70,000. This would decrease the business’s profit from $100,000 to $30,000. Jill would have to pay Medicare taxes of 1.45% ($1,015) and Social Security taxes of 6.2% ($4,340) on her $70,000 salary. The business would also be required to match Jill’s Medicare and Social Security payments.

Total payroll taxes would equal $1,015 (Jill’s Medicare payment) + $1,015 (the business’s Medicare payment match) + $4,340 (Jill’s Social Security payment) + $4,340 (the business’s Social Security payment match) = $10,710.

So in our example if Jill’s business was an S corporation, Jill would pay $15,000 in income taxes + $10,710 in self-employment taxes (Social Security and Medicare) = $25,710.

Rule of thumb – If taxable income is > 30k, you may see advantages of an S corporation.

When Jill’s business turns a profit of $100,000, we showed how her tax liability would be $30,300 as a sole proprietor (or partnership) or $25,710 as an S corporation. That’s a difference of $4,590.

As a general rule of thumb, if your business is generating taxable profits of at least $30,000, it might be worth talking to a CPA to see if converting your business to an S corporation makes sense and can save you money.

S corporations are a great option for lifestyle businesses

President Dwight Eisenhower and Congress were successful in creating a hybrid entity that helped small business owners in the U.S.

With most featuring three or fewer shareholders, very few S corporations have to worry about the hurdles surrounding who can be a shareholder, the number of shareholders, being based in the U.S., and having only one class of stock.

That’s why the S corporation is a perfect fit for these lifestyle businesses whose owner has no grand ambition to grow the business as large as possible and attract as many investors as possible.

S corporation tax filing

An S corporation files its tax return on Form 1120-S. Each shareholder receives a Form K-1 from the S corporation. K-1s report each shareholder’s allocation of income, losses, and other financial information from the business. The shareholder includes Form K-1 information on their individual tax return.

This section discusses filing an S corporation tax return and the associated Form K-1s. If you have an S corporation, please contact our office with any questions about how to file a Form 1120-S or how to include a Form K-1 on your individual tax return.

How to fill out a Form 1120-S

  • Keep your accounting records and financial statements up-to-date. An accurate balance sheet and income statement helps to make preparing your S corporation tax return extremely easy every year and will ensure that you don’t run the risk of reporting too much (or too little) income. If your business grows big enough, you’ll be required to report your balance sheet on Schedule L of your S corporation’s tax return.
  • Record your income. The first section of Form 1120-S is where your business’s income and cost of goods sold are recorded.
  • Record your expenses. The second section of Form 1120-S is where your business’s expenses are recorded.
  • Calculate your net profit or loss. Subtract your total expenses from your gross income to compute your net profit or loss. On an S corporation tax return, the technical name for your business’s profit or loss is “ordinary income or loss”.
  • Record taxes owed and payments made. The vast majority of S corporations do not owe taxes at the business entity level. As discussed before, shareholders normally pay taxes on their share of the business’s profits on their individual tax returns. There are several limited circumstances where an S corporation would owe taxes at the entity level. This is the section where these tax liabilities would be recorded.
  • Answer questions on Schedule B. Stretching over all of Page 2 and on to Page 3 of Form 1120-S, Schedule B can be thought of as a questionnaire that encompasses various areas of your business. The questions range from asking about the business’s stock structure to ownership interest by shareholders.
  • Complete Schedule K. This schedule is what will be used to allocate dollar amounts and other information from Form 1120-S to the shareholders.
  • Complete Schedule L. If required, complete Schedule L. This is where you would report your business’s balance sheet.
  • Complete Schedule M-1. This schedule is where you reconcile taxable vs. non-taxable income and deductible vs. non-deductible expenses.
  • Complete Schedule M-2. This schedule is a more detailed look at the shareholders’ capital accounts.

Information from your Form K-1

The K-1 you receive from your S corporation will contain the following information to report on your individual income tax return: Ordinary business income or loss; Rental income or loss; Interest income; Dividend income; Royalties; Capital gains or losses; Other income or losses; Section 179 Expense; Deductions that don’t get rolled up into the business’s overall profit or loss for tax purposes; Tax credits; Items that affect alternative minimum taxable income; Items that affect shareholder basis.

This is just a quick overview of Form 1120-S and Form K-1. Please call our office if you have any questions about filing a tax return for your S corporation or how to report K-1 information on your individual tax return.

Does an S corporation shareholder need to pay quarterly taxes?

An S corporation shareholder is generally required to make estimated tax payments, as taxes must be paid as you earn or receive income throughout the year, either through withholding or estimated tax payments. Estimated tax payments are used to pay not only income tax, but also other taxes such as self-employment tax and alternative minimum tax.

Deadline to pay your estimated taxes

For estimated tax purposes, your tax year is divided in four payments periods:

  • 1st Payment Deadline – April 15th – Covers income earned from January 1 to March 31
  • 2nd Payment Deadline – June 15th – Covers income earned from April 1 to May 31
  • 3rd Payment Deadline – September 15th – Covers income earned from June 1 to August 31
  • 4th Payment Deadline – January 15th – Covers income earned from September 1 to December 31

NOTE: If the payment deadline falls on a weekend or legal holiday (i.e. Martin Luther King, Jr. Day in January and Washington D.C.’s Emancipation Day in April), you may wait until the following business day to mail or submit your payment.

How to calculate your estimated taxes

Here are some suggestions for figuring out how much your estimated tax should be:

  • A good starting point is to use your prior year Form K-1 received from your S corporation.
  • Next, estimate your expected adjusted gross income, taxable income, taxes, deductions, and credit for the entire tax year.
  • Use the worksheet provided by the IRS in the instructions to Form 1040-ES or call our office for assistance.

If you subsequently discover that your estimate was too high, simply complete another Form 1040-ES worksheet to recalculate your estimated tax when it comes time for your next payment. If your estimate was too low, complete another Form 1040-ES worksheet to adjust your next payment.

How to pay your estimated taxes

You can send estimated tax payments with Form 1040-ES by mail, or you can pay online, by phone, or from your mobile device using the IRS2Go app. You can pay your estimated taxes weekly, bi-weekly, monthly, etc. as long as you’ve paid enough in by the end of the quarter.

Avoid paying a penalty!

If you don’t pay enough tax through withholding and estimated tax payments, you may be charged a penalty and/or interest. You may also be charged with a penalty if your estimated tax payments are late, even if you are due a refund when you file your tax return.

Find out more about our family office financial services

C corporation

Entrepreneurs love solving puzzles, and one of the more complicated puzzles to try and piece together is deciding whether C corporation status makes sense for your business.

Incorporating a business can be expensive and involve ongoing paperwork and compliance requirements. Some businesses should steer clear of the headaches required of maintaining C corporation status.

Other businesses, however, will gladly invest the extra time and money required to incorporate. For businesses that use the C corporation entity structure correctly, the decision to incorporate can offer very attractive legal and tax planning options.

C corporation: The preferred tax shelter from the 1940s to the 1980s

The top marginal tax rate for individual U.S. taxpayers in the 1970s was 70%. Lest you think this 70% rate for the well-off U.S. citizens is too low, you’re in luck. The top marginal rate hovered in the low 90s between 1952 and 1963.

The all-time high tax rate for individuals occurred during World War II, peaking at 94% in 1944 and 1945 for taxable income exceeding $200,000 ($2.5 million in today’s dollars).

So why are we giving you a history lesson about individual tax rates in an article about C corporations?

The U.S. citizens who would have been subjected to these top marginal tax rates surely would have found a way to avoid paying 70%, 80%, or 90% of their income to Uncle Sam. And that preferred way of sheltering their income in the post-World War II era of the American economy was the good-old C corporation.

From tax shelter to forgotten business entity

During the 1950s, when the top individual rate was in the low 90s, the top tax rate on traditional C corporations was 52 percent, almost 40 points lower than the top individual income tax rate.

Even when President John F. Kennedy lowered the top individual rate to 70 percent in 1963, there was still a spread of 22 points when compared with the top corporate rate of 48 percent.

Wealthy taxpayers simply shifted as much of their entrepreneurial income as they could from their individual tax returns into a C corporation.

Continued use of C corporations as a tax shelter by the wealthy started to slow in 1981 thanks to President Ronald Reagan. The top individual rate was lowered from 70 percent to 50 percent while the corporate tax rate held steady at 46 percent.

An expansion in the total number of allowable shareholders in an S corporation and the creation of a new entity called the Limited Liability Corporation also decreased the use of C corporations during the early 1980s.

In 1986, the top individual tax rate of 28% finally dipped below the top corporate tax rate of 34%. Wealthy taxpayers who were still sheltering income using C corporations immediately began reporting most of their income on their individual tax returns by flowing business profits through sole proprietorships, S corporations, or LLCs. Between 1986 and 1996, S corporations and LLCs overtook C corporations as the business entity of choice.

As a comparison, in 1958, C corporations and Partnerships (LLCs) numbered roughly 1 million each, with hardly any S corporations in existence. By 2010, C corporations stood at 1.5 million while Partnerships (LLCs) grew to 3.4 million, and S corporations grew to 4.2 million.

With the proliferation of Partnerships and S corporations, C corporations were now the forgotten business entity, and then tax reform happened.

The effect of the tax reform bill

Just when it looked like S corporations and Partnerships would be the preferred business entity of choice into the indefinite future, President Donald Trump and the U.S. Congress passed the “Tax Cuts and Jobs Act of 2017” in December 2017. This statute lowered the top corporate tax rate from 35% to 21%, which is 16 points lower than the 2019 top individual rate of 37%.

Is it possible that wealthy Americans will shift their business income from S corporations and LLCs back to C corporations? While the tax reform bill lowered the Federal tax rate to 21 percent, it also made available certain advantages to the specified individual and trust owners of partnership and S corporations with a special 20 percent income deduction.

So stay tuned to find out how many S corporations and Partnerships find it more advantageous to switch back to being a C corporation.

Formed by filing Articles of Incorporation at the state level.

So where do C corporations come from?

Both C corporations (and S corporations) are born the same way, by filing Articles of Incorporation with the state in which you want to conduct business. When Articles of Incorporation (also called Certificate of Incorporation or a corporate charter) are filed with the state, your business officially becomes a legal entity separate from its owners called a “corporation.”

Corporations by default must follow the taxation rules contained in Subchapter C of the Internal Revenue Code, hence the name C corporation. (S corporations are taxed according to Subchapter S of the tax code.)

Think of Articles of Incorporation as an application a business fills out to become a “corporation.” While rare, Articles of Incorporation can be rejected for various reasons.

Once approved by your state, Articles of Incorporation become a matter of public record.

Most states require at least the following information to be included with the Articles of Incorporation: Corporate name; Business purpose; Registered agent; Incorporator; Number of authorized shares of stock; Share par value; Preferred shares; Directors; Officers; and legal address of the company.

State of formation vs. State of operations

Did you know you can incorporate your business in any state you want to?

Many businesses choose to incorporate in the state where they conduct most of their business or where their headquarters is located. Corporations, however, have the flexibility to file their Articles of Incorporation in any state.

Incorporating in the same state where your business is located is often the cheaper alternative. If you incorporate in a different state, you’ll still need to pay a fee to register your company in the state where your business is located, in addition to paying a fee to the state where the Articles of Incorporation are filed.

The Delaware C corporation is the gold standard

If you want to file your Articles of Incorporation in a state other than where your business is physically located, Delaware is always a popular choice for several reasons.

First, the Delaware General Corporation Law offers very flexible terms with how a business can structure its corporation and board members. For example, Delaware permits only one individual to be the sole shareholder or officer of a corporation, while other states mandate a minimum of three people holding positions of officer or director.

Second, the Delaware Court of Chancery is the most well-known and respected business court in the United States. This court hears a high volume of corporate cases, which means more predictable outcomes where legal advisors can be on the lookout for precedents and rulings on past cases. The court also uses judges instead of juries. If you find yourself involved in corporate litigation in Delaware, your case will be assigned to a judge who is an expert in complex corporate law matters.

Third, the incorporation process is faster in Delaware than most other states. Delaware also doesn’t require the business to publicly disclose the names of the corporation’s directors or shareholders, which offers an additional layer of privacy.

Finally, Delaware C corporations are preferred by venture capitalists and investment banks. Venture capital firms and angel investors sometimes require start-ups to be Delaware corporations before funding is provided. According to Delaware’s “Division of Corporations” website, more than 66% of Fortune 500 companies have chosen Delaware as its legal home.

Strict year-end requirements for properly maintaining C corporation status

A common reason for incorporating a business is to limit the personal liability of the shareholders if the company is sued. Limiting personal liability, however, isn’t a benefit that’s granted indefinitely after the Articles of Incorporation are filed.

A C corporation must remain in good standing with the state in which the Articles of Incorporation were filed (this also applies to LLCs) at all times by adhering to a prescribed list of rules in order to maintain limited liability. If the corporation finds itself not in good standing, a third party can sue the business and come after both the business’s assets as well as the shareholders’ assets. This is commonly referred to as “piercing the corporate veil.”

Here are some of the most common rules that must be followed to maintain a C corporation’s “good standing”:

  • File annual information reports – Most states require some type of annual information report. Double-check due dates – some reports need to be filed when tax returns are due, others are due on the anniversary of the incorporation or at the end of the calendar year.
  • Keep corporate minutes and resolutions – Minutes, also known as “minutes of the meeting,” are the contemporaneous written record of a meeting. Minutes content typically includes time and place of meeting, individuals in attendance and the chair of the meeting, decisions made or actions are taken, along with the signature of the recorder and the date. Meeting minutes should be recorded even if there is only one corporate owner. Minutes are often used as a defense in court to protect a corporation’s ability to limit shareholder personal liability.
  • File amendments to record any changes – Changing an address, changing a website URL, issuing more shares of stock – any change to the corporation must be reported to the corporation’s home state by filing an “amendment” to the original articles of incorporation. Many states refer to these changes as “Articles of Amendments.”
  • Keep business finances separate from personal finances – For a small business owner, keeping separate checking accounts for business and personal transactions can be a hassle. But if you incorporate your business, maintaining separate accounts is a requirement. There should be separate accounts for everything money-related in a corporation – checking accounts, savings accounts, credit cards, etc. Keeping separate business accounts will also make tax time easier since all business income and expenses will be in one place.
  • Register in all states where the corporation conducts business – A corporation operating in a state other than where the Articles of Incorporation were filed is referred to as a “foreign corporation.” Other state-specific licenses and permits may also be required.

Corporate bylaws set rules and are enforced by the board of directors

Bylaws are the rules of a corporation that will be performed throughout the organization’s existence. Bylaws govern how a company is operated and are one of the first items to be created by the board of directors. While the bylaws are often included with the Articles of Incorporation as a single document, bylaws, and Articles of Incorporation are legally separate, distinct documents. Bylaws are not required to be filed with the state of origin’s agency of business registration.

Bylaws should contain the following sections:

  • Board of Directors – The board is the governing body of the corporation. The bylaws should outline the board’s powers and duties, the number of years a member can remain on the board, the number of members required to form a quorum, and how to replace a member.
  • Identification Information – Name, address, and principal place of business; designation of the corporation as public or private
  • Stock Information – If the organization is a stock corporation, the bylaws should have information about stockholders and voting shares of stock, the number, and type of shares, and the types of stock classes the corporation is authorized to issue
  • Statement of the Company’s Purpose – Explains why the company was formed; may be helpful with attracting investors because of a central location to ascertain what the company is all about
  • Shareholder and Board Meeting – Bylaws should indicate when, where, and how often shareholder meetings take place and how to notify shareholders of these meetings.

Preferred entity structure for institutional investors (i.e. venture capitalists)

C corporations make dividing ownership easy through the issuance of stock. Dividing ownership can also be done with other entity forms, such as LLCs, but it is significantly more complicated.

Ease of dividing ownership is one reason why institutional investors prefer – and sometimes require – a business to be a C corporation.

Some investors don’t want just any C corporation – they prefer a Delaware C corporation. As detailed in an earlier section of this article, the state of Delaware features a corporation-friendly court system as well as formation flexibility.

If you know for certain that your business will be welcoming investors in the future, consider making your business a C corporation from the very beginning. You can always start a business as an LLC or an S corporation, then convert to a C corporation, but that process could be very expensive and time-consuming.

Easier to issue stock-based compensation packages

In the early days of a start-up company when cash can be at premium, new employees can be incentivized to work for the start-up by being offered equity incentives. Stock-based compensation packages are also a great way to tie the employee’s financial rewards to the success of the company.

Several of the equity-based incentive plans allow employees to defer paying tax on the equity compensation they receive until the underlying stock associated with the incentive package is sold. When the employee sells the stock at some point in the future, the employee will then recognize income and the business can recognize a wage and salary deduction.

While LLCs can offer their members or partners what is called a “future profits interest,” it can’t offer a future value of the partnership as a compensation arrangement. So if the business wants to tie compensation to the equity of the business, the C corporation is the easiest way to structure this type of pay package.

Stock Options and Restricted Stock

Most equity compensation packages are offered as either grants of stock options or issuances of restricted stock. Stock option plans are more common with startups while restricted share plans are more common for established companies.

Here is a quick look at the most common types of stock grants and options:

  • Stock Grant of Restricted Shares – Restricted shares are shares of a business’s stock that vest over time to an employee. An employee cannot sell the stock until the shares have vested. Receiving restricted shares is not a taxable event and doesn’t cost anything to the employee. When a restricted share finally vests, the employee must recognize the vested share’s fair-market value as ordinary income. The employee also must pay either short-term or long-term capital gains when the stock is eventually sold.
  • Stock Grant of Unrestricted Shares – Rather than restricting when an employee can be awarded stock of a business, shares can be immediately transferred outright to the employee. While receiving unrestricted shares gives an employee immediate equity in a company, it also means the employee must immediately pay taxes on the fair market value of the shares less the amount paid for the shares.
  • Incentive Stock Options – With an Incentive Stock Option (ISO) compensation plan, the employee does not have to pay taxes until the stock is sold. If certain holding period requirements are met, the stock sale proceeds will also be eligible for long-term capital gains treatment. With ISO’s, the C corporation does not receive a deduction when the employee sells his or her shares if the long-term capital gain holding requirements are met.
  • Non-Qualified Stock Options – With a Non-Qualified Stock Option (NQSO) compensation plan, an employee is permitted to acquire an agreed-upon number of stock shares at a future date (or dates) for a pre-determined price. (These plans are called “non-qualified” because they do not meet all the criteria required by the IRS to qualify as ISOs.) For example, an employee is hired January 1, 2022 and provided an NQSO plan. The NQSO states that the employee can purchase one share of the company’s stock for $50 at a future date. On January 1, 2024, the employee purchases one share of company stock for the agreed-upon $50 while the fair market value of the share was $60. The employee must include as income on their tax return the fair market value of the stock at the time it was acquired less any amount paid for the stock. In our example, the employee would have to include income of $10 (FMV of $60 less $50) as income on their tax return.

Earnings do not pass through to owners unless the board of directors specifically elects to issue dividends

Profits of a C corporation go into a bucket called “accumulated earnings and profits.” A dividend is a distribution made to shareholders from cash found in this “accumulated earnings profits” bucket. So another way to think about dividends is that they are distributions of earnings by a corporation to its stockholders.

But how, exactly, do dividends end up in the hands of stockholders? Only the board of directors can declare dividends. Dividends are usually paid quarterly, though a company can issue special, one-time dividends under special circumstances.

Easier for mergers, acquisitions, and IPO readiness

Instead of starting a business from scratch, suppose you wanted to buy a business instead.

One option is to purchase the individual assets of the company you wish to acquire. There would be separate transactions for all the assets on a balance sheet – accounts receivable, fixed assets, inventory, any intangible assets, etc. If there were any liabilities, those also might affect the purchase price of the assets.

Entering into separate transactions for each of a business’s assets can quickly become very cumbersome.

Instead of buying individual assets, a C corporation allows a potential buyer to purchase the company via shares of stock. Each share represents a fractional amount of the balance sheet, which makes mergers and acquisitions which are completed via stock swaps quick and easy.

B-Corporations (benefit corporations) are also C corporations with a specific designation

A Certified B-Corporation, also known as a benefit corporation, is a type of for-profit corporate entity recognized by 35 states and the District of Colombia. These corporations create value not only for their stockholders but also for society at large.

B Corporations are companies certified by “B Lab” as meeting certain standards of social and environmental performance, accountability, and transparency.

Don’t be fooled by the name “benefit corporation,” however. B-Corporations are taxed just like C corporations. They are not considered non-profit entities.

C corporation tax rates

As previously mentioned, C corporation profits are actually taxed at the entity level, unlike SMLLCs and S corporations, whose profits are taxed at the individual shareholder or owner level. The current tax rate for C corporations is a flat 21%.

When are C corporation tax returns due?

Tax returns for calendar-year C corporations are due April 15. C corporations must also make estimated tax payments if required. First-quarter payments are due April 15th; second-quarter payments are due June 15th; third-quarter payments are due September 15th; fourth-quarter payments are due December 15th.

A C corporation with a fiscal tax year must generally file its tax return by the 15th day of the 4th month after the end of its tax year. The one exception to this rule is for a C corporation that has a fiscal year ending June 30th, whose due date is the 15th day of the 3rd month after the end of its tax year (i.e. September 15th).

How are C corporations taxed?

A C corporation files its tax return on Form 1120. (Don’t confuse this form with Form 1120-S, which S corporations use to file tax returns.) Shareholders can receive money from the corporation in the form of wages or salary (for which they would receive a Form W-2), or dividends (reported on Form 1099-DIV), but a C corporation shareholder does not report an allocated amount of revenue and expenses like an S corporation shareholder does.

This section discusses filing a C corporation tax return. Please contact our office with any questions about filing a Form 1120, Form 1099-DIV or a Form W-2.

How to fill out a Form 1120

  • Keep your accounting records and financial statements up-to-date. An accurate balance sheet and income statement helps to make preparing your C corporation tax return extremely easy every year, and will ensure that you don’t run the risk of reporting to much (or too little) income. If your business grows big enough, you’ll be required to report your balance sheet on Schedule L of your C corporation’s tax return.
  • Record your income. The first section of Form 1120 is where your business’s income and cost of goods sold is recorded.
  • Record your expenses. The second section of Form 1120 is where your business’s expenses are recorded.
  • Calculate your net profit or loss. Subtract your total expenses from your gross income to compute your net profit or loss. On a C corporation tax return, the technical name for your business’s profit or loss is “taxable income (or loss)”.
  • Calculate taxes owed and payments made. Calculate your C corporation’s tax liability according to the Form 1120 instructions. Also record any payments made during the tax year along with any tax credits.
  • Determine balance owed or overpayment. The final dollar amount on Page 1 of your Form 1120 will tell you either how much money you still owe the U.S. Treasury or how much money you overpaid to the U.S. Treasury.
  • Complete Schedule C. This schedule calculates any dividends that will be distributed to shareholders, along with various special deductions.
  • Complete Schedule J. This schedule is where you will compute the tax liability of your C corporation.
  • Complete Schedule K. This schedule contains miscellaneous questions and information about your C corporation.
  • Complete Schedule L. If required, complete Schedule L. This is where you would report your business’s balance sheet.
  • Complete Schedule M-1. This schedule is where you reconcile taxable vs. non-taxable income and deductible vs. non-deductible expenses.
  • Complete Schedule M-2. This schedule is a more detailed look at the C corporation’s retained earnings.

Summary of C corporations, S corporations and Single Member LLCs

Whether to register an S corp, C corp or LLC entity is dependent on various factors and needs within your business.

Here we discuss the key features of each to help you gain an understanding of the entity status best suited to your business.

C corporations

The grandfather of business entities, the C corporation has come back in vogue the past 36 months thanks to the “Tax Cuts and Jobs Act of 2017,” which cut the tax rate for C corporations from 35% to 21%.

Famous (or rather infamous) for its double taxation of earnings, the C corporation is the preferred entity structure for venture capitalists and other institutional investors for two primary reasons:

  1. It’s easy to transfer ownership from an existing shareholder to a new or incoming shareholder, and
  2. The C corporation structure provides liability protection for the shareholders.

These significant benefits of easy ownership transfer and liability protection come at a cost, however: Double taxation and lots and lots of paperwork.

So what, exactly, do we mean when we say a C corporation’s earnings are taxed twice? The first layer of taxation happens at the entity level. The business itself pays a 21% tax on any net profit.

The second layer of taxation occurs when a shareholder wants to take money out of the business. While there are tax planning strategies to minimize this layer of taxation, in general, a shareholder must pay taxes on money taken from the business. The most common form of cash distribution from a C corporation to its shareholders is through a dividend. The maximum tax rate for dividends in 2019 is 20% (an additional 3.8% federal net investment income tax may also apply, bringing the total tax rate total to 23.8%).

To summarize, the primary drawbacks of organizing your business as a C corporation are double taxation, the high cost of filing the necessary paperwork to create the C corporation, and the ongoing legal and administrative work necessary to keep a C corporation in compliance with local, state, federal and international laws.

But for the right type of business, shareholder or investor, the benefits of organizing as a C corporation outweigh the aforementioned drawbacks.

S corporation

Not every business wants to attract institutional investors or eventually go public. Owners who want the liability protection of C corporations but an easier way to satisfy tax filing obligations can utilize the S corporation.

The reason why S corporations are not attractive to institutional investors are the three ownership limitations:

  1. The number of S corporation shareholders is limited to 100 or less;
  2. S corporation shareholders can only be individuals, estates, and certain types of tax-exempt entities and trusts (other business entities cannot be a shareholder); and
  3. S corporation shareholders must be U.S. citizens or permanent U.S. residents.

While these three ownership limitations cause institutional investors to shy away from S corporations, these ownership limitations are usually not an issue for the vast majority of business owners who are not institutional investors.

Many S corporation businesses, in fact, are “lifestyle” businesses that have only a handful of shareholders. These businesses will never have to worry about exceeding the 100 shareholder limit.

Another significant benefit of organizing a business as an S corporation is only dealing with one layer of taxation. While C corporation profits get taxed at the entity level, S corporation profits do not get taxed at the entity level. The profits from an S corporation flow from the business to the shareholder and get reported on the shareholder’s individual tax return.

Distributions from an S corporation to a shareholder are (generally) not taxable, while dividend distributions from a C corporation are subject to tax.

While there are limitations to who can be an S corporation shareholder, many businesses will never need to worry about these limitations. That’s why the S corporation entity is a very attractive option for smaller businesses with a limited number of owners.

Single Member Limited Liability Company

The most popular form of business entity today in the United States is the Limited Liability Company (LLC). An LLC with just one owner is referred to as either a “Single Member LLC” or a “disregarded entity” (since the IRS “disregards” the LLC entity for federal tax purposes.)

While LLCs and S corporations share many of the same characteristics, such as limited liability and pass-through taxation, there are several important differences that make the LLC a very popular choice of business entity.

First, LLCs do not have the shareholder limitations that S corporations face. States do not enforce any limitations on the number of members an LLC can have. (Owners of an LLC are called members, not partners.)

Second, S corporations must allocate profits and losses pro-rata. For example, an S corporation with two shareholders and an income of $100 for the most recent calendar year must divide the $100 equally, $50-$50, between the two shareholders.

LLCs (and all other forms of partnerships) can take that $100 of income and allocate $80 to one member and $20 to the other member, for example. This same type of special allocation can be done with expenses, as well. The flexibility to allocate economic transactions is a significant advantage of forming a business as an LLC. (There are guidelines for making special allocations that will be discussed in an upcoming article.)

The flexibility to make special allocations of income and expenses, however, comes with a downside – compliance requirements can become very significant, both in terms of time and money. Many attorneys and CPAs agree that the most complex component of the U.S. tax code is the section that governs partnerships (Subchapter K).

But don’t let these potential compliance requirements scare you from organizing as an LLC. Many smaller partnerships don’t consistently encounter these more complicated tax scenarios.

If your LLC does end up encountering these more complicated tax situations, chances are the business has grown to the point that the financial resources will be available to properly meet your compliance obligations.

How is Partnership Taxed?

If you start a business with at least one other person and don’t incorporate, by default your business is a general partnership.

A general partnership is easy to start, does not require filing any paperwork with your particular state, and doesn’t require certain compliance activities such as recording minutes of meetings. Each partner can also deduct their share of business expenses on their individual tax return.

Another advantage of forming a business as a general partnership is flexibility when drafting partnership agreements. While profits of an S-Corporation must be allocated pro-rata, a general partnership can allocate a non-proportional amount of income (or expenses) to a specific partner or partners.

The biggest drawback of a general partnership is the absence of liability protection. Each partner of the business is personally liable for the business’s debts and other liabilities. In some states, each partner may also be personally liable for one of their fellow partner’s negligent actions.

As a general partnership begins to grow, it may also become difficult to qualify for a business loan, attract significant clients and build a credit history.

A general partnership may make sense to quickly get a business off the ground. Then, after a period of time, the general partnership can incorporate into either a C-Corporation or a Limited Liability Company.

Partnership tax advantages

Are you planning to start a business sometime soon? Maybe you’re a current business owner who started an enterprise sometime in the last 20 years?

If you’re a current or soon-to-be small business owner in the United States, chances are you’ve heard about or considered becoming a Limited Liability Company (LLC). Organizing your business as an LLC could be a perfect match for small businesses looking for flexibility and limited liability. LLCs are also one of the most common ways to incorporate a partnership.

NOTE: LLCs can be taxed either like a sole proprietorship (single-member LLC), a partnership, a C corporation, or if it qualifies, an S corporation. LLCs in this article is considered to be a partnership, with the terms LLC and partnership used interchangeably.

ADDITIONAL NOTE: While the owners of partnerships are referred to as “partners”, the owners of LLCs are technically called “members”. Some sections of this article will only refer to partners, other sections only members, and some sections will refer to both partners and LLC members. For federal tax purposes, there is normally no distinction between “partners” and “members”.

Before LLCs, C corporations used to be your only option if you wanted limited liability for your business. The C corporation structure, however, was not a good fit for all small businesses because it subjected the business owner(s) to two layers of federal tax – one at the corporate level and a second at the individual level.

S corporations were eventually created to provide relief from double taxation, preserving the C corporation benefit of limited liability while adding the feature of passthrough taxation. There were still limitations, however, as discussed later in this article.

There was still a need for a business entity that features the limited liability protections of a corporation with taxation principles of partnerships. At the prodding of Denver-based Hamilton Brothers Oil Company, the Wyoming legislature passed the first LLC Act in the U.S. in March 1977. It wasn’t until September 2, 1988, however, that the IRS finally gave the ok to tax LLCs under partnership taxation rules.

After the IRS’s 1988 ruling, other states began to introduce their own LLC provisions.

Offers limited liability, no ownership restrictions. As its name implies, an LLC offers limited liability to all its members. Similar to an S corporation, the owners (owners of an LLC are referred to as members, not partners) of an LLC are not personally liable for the company’s debts or liabilities. LLCs also have no ownership restrictions like an S corporation. Anyone can become a member of an LLC, including corporations, foreign individuals, and other LLCs.

By contrast, S corporation ownership is limited to U.S. citizens who are natural persons. Corporations, partnerships, and non-resident aliens are not permitted to be an S corporation shareholder.

LLCs can have one or more members. While the terms LLC and partnerships are sometimes used interchangeably, LLCs can exist with only one member. The IRS considers an LLC with one member to be a “disregarded entity.” This means that the IRS “disregards” the LLC entity and treats the business like a sole proprietorship for tax purposes. LLCs with one member is also referred to as “single-member LLCs” or SMLLCs.

Where does an LLC come from?

Similar to corporations, which are formed by filing Articles of Incorporation with the state in which the business will be located, LLCs are also formed by filing Articles of Organization at the state level. To file the Articles of Organization, you’ll need the LLC’s name, name and mailing address of the registered agent and possibly other identification information.

Here are some of the other common requirements for forming an LLC:

  • Identify Registered Agent – A “registered agent” is an individual that your business designates to receive official papers for your organization, such as tax and lawsuit notices. LLCs are required to have a registered agent in each state it is registered in to conduct business.
  • Choose type of management – Most LLCs are managed by its members. In this arrangement, all members take part in the decision-making process of the business. Each member is an agent of the LLC and has a vote in all business decisions. In a manager-managed LLC, the members turn over control of the business to a manager, which becomes the agent of the company. A member-managed structure is the default status in most states. If the LLC wants to be managed by a 3rd-party manager, it must be designated as such in the operating agreement.
  • Operating agreement (see more below) – The operating agreement is an internal document that spells out how the LLC will operate and be run. While most states do not require an LLC to have an operating agreement for registration purposes, it is often a good idea to have one. In the absence of an operating agreement, state law will govern how the LLC operates.
  • Employee Identification Number (EIN) – If the LLC has more than one member, it must get an EIN number from the IRS.
  • Out-of-State Registration – LLCs are required to register in each state where it conducts business, including appointing a registered agent for each state.

State of formation vs. state of operations

There are two types of LLCs: “Domestic” and “Foreign.” A domestic LLC only conducts business in the state where it is formed. A foreign LLC conducts business in a state other than where the business was formed and initially registered. A U.S.-based LLC, for example, would be registered as a domestic LLC in one state and registered as a foreign LLC in all 49 other states.

Because of the additional administrative and compliance work required to register and operate a business as a foreign LLC, smaller businesses should consider registering in the state where you expect to conduct most or all of their business. As you obtain customers in additional states, you can then register your business as a foreign LLC in additional states.

The operating agreement governs the operations of the business, enforced by the member/managers

Does your LLC legally need an operating agreement? No, it does not. But every tax and a legal advisor will probably tell you that you should.

An operating agreement is the primary governing document of the LLC and is very similar to a partnership agreement. It spells out the company’s interests, activities, management, and provisions governing the rights and obligations of its members.

Here are some of the more common sections of an operating agreement to be aware of:

  • Equity Structure – This section details the ownership percentages of each member. Initial capital contributions, which can be either cash or non-cash contributions, are detailed. Other rules governing future contributions and distributions would also be included in this section, along with whether members are allowed to carry a negative capital balance.
  • Profit and Loss Allocations – Default allocations according to state law are made proportionately according to capital accounts. Non-proportionate allocations may be made if included in the operating agreement. For example, a member who has a 25% interest in the LLC can be allocated 50% of the LLC’s profits or losses in a particular year if this is disclosed in the operating agreement.
  • Management – Do the members of the LLC manage the day-to-day operations of the business, or will a non-member manager be appointed? How are non-member managers appointed and what authorities are they granted?
  • Voting – The default rule for LLCs is one vote per member, regardless of ownership percentage. If an LLC wants to have voted based on ownership percentages, this option must be identified in the operating agreement.
  • Different Membership Interests – Various membership interests can be formed. Examples include non-voting interests, preferred interests, and profits-only interests.
  • Anti-Dilution Protection – Every time a new member is admitted to an LLC, the ownership percentages of the existing partners decrease. Anti-dilution provisions prevent ownership percentages of existing members from decreasing by permitting one or more existing member(s) to keep his original ownership interest percentage whenever the LLC votes to add new members.
  • Restrictions on Transfers – Can membership interests be assigned to individuals outside the LLC? Do membership transfers require unanimous approval from all members or only a certain percentage of members? Does the LLC have the “right of first refusal” when a member wants to sell his interest? Is there a buyout clause that describes the steps of how a buyout will take place?
  • Liquidation and Dissolution – When members are ready to dissolve the business, this section details how an LLC’s assets will be liquidated. A typical liquidation begins with paying off the LLC’s liabilities, followed by distributions to members according to their capital accounts. Lastly, any remaining assets are distributed to members according to their percentage interests.

These are just several of many different provisions that can be included in an operating agreement. Having a team of advisors who are experts in LLCs, including CPAs and attorneys, is critical to not omitting important sections of the agreement.

Must file an annual report each year to remain in good standing

Many states require LLCs to file an annual report to remain in good standing. These reports usually require the business to provide the state with identification information, such as the names and addresses of directors along with the LLC’s registered agent’s name and mailing address.

Some of these annual reports, such as Texas’s franchise tax report, only require an annual filing and no corresponding fee unless the tax is owed. Other annual reports, such as California’s franchise tax report, requires an annual minimum fee of $800 regardless of whether or not the LLC reported a profit.

Partnership taxation

Similar to S corporations, LLCs (and partnerships) are considered “pass-through” entities where a business’s income and expenses flow through to the partners and are reported on the partners’ personal income tax returns.

The most significant tax difference between LLCs and S corporations is the treatment of self-employment taxes. In an LLC, each member’s share of profit is subject to self-employment tax. In an S corporation, each shareholder’s share of profit is NOT subject to self-employment tax. The IRS does, however, require S corporations to pay shareholders who contribute substantial services a “reasonable” salary. This salary is subject to payroll taxes.

Here are several other significant areas of LLC taxation:

State Taxation – Partners need to be aware that some states require LLCs to withhold taxes on behalf of the partners. This withholding is oftentimes mandated using the state’s highest marginal rate.

Partnership Audit Rules – Legislation in 2015 instituted new procedures for federal audits of partnerships. Audits will now be conducted, and any additional taxes will be levied, at the partnership level. Partnerships and LLCs have the option to elect out of these new audit rules. Under the old rules, the IRS would be forced to collect any additional taxes levied from the partnership’s partners, not the partnership itself. This election to opt-out of the new audit rules must be made annually.

Special Allocations – Another tax-related advantage that partnerships have over S corporations is being able to implement special allocations. As an example, let’s consider an LLC that has four members, each of whom owns 25% of the LLC. The LLC isn’t required to allocate 25% of the LLC’s profits and losses to each member. If agreed on by all the members and documented in the operating agreement, one of the members can be allocated 50% of the LLC’s profits and losses while the other three members split the remaining 50%. There are guidelines and limitations for how an LLC can structure special allocations. Please consult your tax advisor for more information.

Complicated Annual Reporting – While special allocations are what has partially made LLCs a popular business entity, special allocations can also cause tax compliance to become expensive and time-consuming for the LLC itself and its members. Complex tax consequences shouldn’t deter you from at least considering the LLC structure for your business with your team of advisers. The benefits of having an LLC may be greater than the time and money resources required to comply with state and federal tax laws.

Flexibility – An LLC always has the option of choosing to be taxed as an S corporation instead of a partnership. The LLC files Form 2553 with the IRS to make the election to be taxed as an S corporation. This is the same form used by a C corporation that elects to be taxed as an S corporation.

Investors prefer C corporations over LLCs

For all the aforementioned reasons why LLCs make sense to use as the entity of choice for the majority of businesses formed today, LLCs are still frowned upon by institutional investors for the following reasons:

  • Taxes – First, investors don’t want to be burdened with the compliance requirements of being a member of an LLC. U.S. federal partnership taxation can get complicated and expensive. Investors don’t want their individual taxes to be either complicated or expensive. There are also potential state reporting requirements if the LLC is considered to have an active trade or business in one or more states. While members of an LLC have annual tax reporting obligations, investors in a C corporation only deal with tax reporting requirements when they sell their shares in that C corporation.
  • Legally can’t invest – Certain investors, such as venture capital funds, are unable to invest in partnerships if the VC fund has tax-exempt partners. These partners can’t accept active trade or business income due to their tax-exempt status.
  • Delaware C corporation is the standard – Many investors and venture capitalists prefer businesses they invest in to be Delaware C corporations for several reasons. First, the Delaware Court of Chancery hears numerous corporate cases every year and makes it easy to research prior court cases and precedents. The court also features judges instead of juries. These judges are subject-matter experts in C corporations. Second, Delaware makes it easy to form a C corporation and offers flexibility regarding how to structure the business and its board members.

Can an LLC be converted to a C corporation?

“Can’t I just start my business as an LLC and convert it to a C corporation at a later date?” Yes, you can start your business as an LLC and incorporate it at some point in the future.

There are 3 different ways to convert your LLC to a C corporation:

  • Statutory conversion – A “certificate of conversion” is filed with your particular state that converts LLC members to stockholders of your new corporation, and transfers assets and liabilities from the LLC to your new corporation. The LLC then ceases to exist. This option is usually the quickest and least expensive way to convert an LLC to a corporation.
  • Statutory merger – Similar to a statutory conversion, except there are more steps and paperwork involved.
  • Non-statutory conversion – This is the most complicated and expensive way to convert an LLC to a corporation. You should usually be able to avoid using this type of conversion.

Please discuss which conversion option is right for you with your tax and legal advisors, as there can also be potential tax consequences with each conversion method.

Partnership tax implications

A partnership, or an LLC operating as a partnership, pays taxes just like every other individual taxpayer according to the individual income tax rates published by the Internal Revenue Service. The current tax rates range from 10% to 37%. Here are the tax rates that will apply when filing your 2021 tax return by the April 2022 tax deadline:

Here are the tax rates if you are single:

[insert table]

Tax rates if you are married:

[insert table]

Tax rates if you’re a single parent:

[insert table]

Tax rates if you’re married but separated:

[insert table]

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This blog article is not intended to be the rendering of legal, accounting, tax advice or other professional services. Articles are based on current or proposed tax rules at the time they are written and older posts are not updated for tax rule changes. We expressly disclaim all liability in regard to actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.