As a company evolves, re-evaluating the entity’s corporate structure from time-to-time will ensure the business is optimizing its balance sheet. This analysis should occur periodically throughout the company’s life cycle, and ideally before the owner decides to sell the business. A thorough assessment may identify opportunities to decrease tax liabilities, boost the company’s valuation, and uncover opportunities within the capital structure.
Traditionally, most startups initially register as an LLC or S-Corp as shareholders can always file to change the corporate structure to a C-Corp at a later date. If the owners try to change a C-Corp to an LLC or an S-Corp, however, they may face adverse tax consequences. While every business model has its own pros and cons in terms of tax efficiency, it can be worthwhile to examine alternative structures to optimize a company’s balance sheet.
Limited liability company
An LLC is a legal structure that combines the limited liability features of a corporation with tax efficiencies associated with a partnership. An LLC is not taxed as a separate entity, nor does it pay out dividends. Owners of an LLC are actually referred to as “members” who personally include profits and losses from the business on their individual federal tax returns. Because of this “pass-through” tax treatment, the members of the LLC are responsible for any taxes that might be due.
This LLC structure provides a layer of protection for members, as they are not personally liable for debt sustained by the company.
“Both S-Corps and LLCs can deduct pre-tax business expenses.”
Much like an LLC, an S corporation also has a pass-through taxation benefit, whereby individual shareholders are responsible for the tax liability rather than the company’s profits and losses. Both S-Corps and LLCs can deduct pre-tax expenses, such as health care premiums, equipment, office supplies, and other business necessities.
While regulations currently cap the number of shareholders for an S-Corp at 100, research shows that roughly 97 percent of these companies only have three or four shareholders. These structures work well for smaller-sized enterprises that have limited input from a small pool of shareholders. Once the S-Corp has paid all employees wages with the appropriate taxes deducted, the remaining profits can be distributed as dividends to the owners, which the IRS taxes at a lower rate.
Most companies that are either operating with more than 100 shareholders or are publicly traded, or both, are typically registered as C corporations. Even though these companies are traditionally larger than the other entities, there are no size restrictions precluding the owner of a smaller enterprise from structuring it as a C-Corp.
C-Corps are considered separate tax-paying entities. Unlike LLCs or partnerships, C-Corps are required to pay income tax on the company’s profits. Any shareholders who are also employees will in turn pay income tax on their wages in addition to any tax due on dividends received. From a liability standpoint, C-Corps retain any and all legal responsibilities for any actions or debts the business incurs. C-Corps can also accumulate earnings that can be used for future bona fide business reasons and are subject to a lower tax rate. According to the IRS, under the Accumulated Earnings Tax, earnings are taxed at a 15 percent rate, allowing these companies the ability to defer significant tax obligations and still grow the business.
Interested in learning more about the differences between S corporations and C corporations? Flip through the SlideShare below: