Tax Consideration while Setting-Up LLC or C-Corp in the US
LLC – These are referred to as “pass-through” entities. LLC’s split their losses for the year based on some percentage, either a profit/loss percentage or a special allocation percentage, between the owners. The owners then report their respective share of the LLC losses on their individual tax returns for the year. Depending on the tax passive loss rules and tax basis rules, the owners may be able to deduct their share of the LLC’s losses against their other income sources for the year, which then reduces their overall tax for the year.
C-Corp – In the eyes of the IRS, these are taxable entities and hence the company is subject to tax at the entity level. The company does not pay any tax that year if the company generates a loss. It is vital to note that this is applicable for federal tax as well as many states taxes too. However, regardless of profitability, some of the states do have minimum tax amounts that are assessed regardless of profitability.
Applicability of annual tax reporting with an ownership interest in the entity?
LLC – Owners are subject to yearly tax reporting. This reporting is done by way of a ‘Schedule K1″ from the LLC to the owner. For the year, the owner’s share of profit or loss, the K1 is how the enterprise reports. The owner will have to wait for the company’s tax return to be completed for the year, since the K1 is needed to file with the owner’s individual tax return for the year.
C-Corp – Just as the owners do not benefit from the C corporation’s losses for the year, on the C corporation’s taxable income for the year, the owners are not subject to tax. There is no additional tax reporting from the C corporation to the owner for the year.
Who pays tax once the company becomes profitable?
LLC – Just as the owners benefit from the tax losses from the LLC, they are also responsible for paying the tax on the company’s taxable income for the year. At the owner level, the company’s profit is taxed. Company’s profit is taxed only one time at the owner level. Since the owners pay tax on the company income, most LLCs will make cash distributions to the owners to pay the tax. These tax distributions are effectively the company using its cash to pay the taxes.
C-Corp – The company pays the tax in profitable years, just as the company benefits from its tax losses. As tax returns are not impacted by company tax profit, there is no need to pay tax distributions to the owners.
Does double taxation apply?
LLC – An LLC is not subject to double federal tax, except state-level LLC tax. For an LLC owner, as long as they have a “tax basis” in their cash distributions, they do not have to pay additional tax on those distributions. The LLCs that are profitable, pay tax on the profit one time which is done at the owner level.
C-Corp – Profits, when paid out to the owners as dividends, are taxed two times. The first time is when the company pays the tax on its profit for the year. The second time is when the owners are paid a dividend for the year because the owners are subject to tax on their dividend payments from the company.
Are there tax benefits when selling ownership?
LLC – If ownership is held for over a year, apart from long-term capital gains tax, there are no extra benefits for the owners at the time of sale for LLC ownership.
C-Corp – For owning qualified small business stock, there are tax benefits on the stocks of the business corporation. For at least five years, if the owner holds their stock, they can sell the stock and avoid paying tax on the first $10 million in gain on the stock. This can be a huge tax benefit and incentive to invest in C-Corp that are Qualified Small Businesses. Further, structuring options may be considered by converting to C-Corp prior to a significant funding round. The tax gain exclusion is lost, if the qualified small business stock is sold within five years. However, if those proceeds are used to purchase new Qualified Small Business Stock, then the gain on the sale of the first stock is deferred until the new stock is sold.
None of the above would be the sole decision point for deciding between an LLC and C-Corp. Discussion around all of the above factors, as well as the legal implications of each entity, should be done prior to determining the legal type of entity and/or raising capital from Investors.