Selecting an entity to start a business sometimes seems inconsequential but it is necessary to choose between one of two feasible options – LLC or C–Corp. It is a crucial decision, as it impacts everything – right from raising the capital to how much the tax the owner pays in the scenario of selling the start-up / company.
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.