Comparison of Different Entities

There are several entities to choose from when starting a business or converting from a sole proprietorship or general partnership. Usually the main reason for forming an entity is for liability protection of the owners. Yet there are many other business and tax issues to resolve. This article only addresses some of the most common issues.

1) C Corporations — The C corporation is taxed at progressive rates that rapidly increase. A C corporation must pay tax on any profit it earns if it pays dividends to its shareholders or distributes/liquidates its assets, and the shareholders pay income tax resulting in a double tax between the two. There are certain benefits to operating as a C corporation, such as being able to perform tax-free exchanges, adopt a medical reimbursement plan (over and above an insured plan) and no limits on the type and number of shareholders.

2) S Corporations — S corporations are taxed similar to LLCs and partnerships, and in addition to the $800 minimum tax they pay 1.5 percent on net income, but no gross revenue tax.

There are several key characteristics of S corporations, one of which is it avoids a double tax resulting from a sale of assets and distribution of the proceeds to the shareholders. Also, there are several requirements to be an S corporation and specific restrictions to maintain that status, such as prohibition of two classes of stock, and the limitation on the number and type of shareholders (e.g., no nonresident aliens).

3) Gross Revenue Tax — An LLC and partnership (limited or general) are taxed exactly the same as partnerships, but LLCs are also subject to a gross revenue tax (not a net profit but a tax based on gross revenue). This progressive tax is as follows:

Gross Revenue Tax

(Equal to or over) (Not over) (The fee is)

$250,000 $499,999 $900

$500,000 $999,999 $2,500

$1 million $4,999,999 $6,000

$5 million and over: $11,790

4) Profit and Loss — This is a tax concept and does not necessarily relate to cash. Assume that a startup S corporation borrows $50,000 to buy equipment, which is depreciated over five (5) years so that the corporation obtains a $10,000 tax deduction in its first year. In the same year it generates $100,000 in cash, and assuming no other expenses at the end of the year it pays off the $50,000 loan and distributes $50,000 to the shareholders. The result is that the corporation will pass through to the shareholder $90,000 of taxable profit but there will only be $50,000 of cash distributed.

Advantages


Typical benefits of operating as an LLC include:

  • Owners (called members) protected from personal liability for debts of the business
  • Members can participate in management and still gain personal liability protection
  • Partnership taxation -- no double taxation, flexible allocations, few restrictions on ownership
  • Can operate most kinds of businesses

How Does an LLC Compare to an S Corporation?


Like an LLC taxed as a partnership, an S corporation (a corporation that elects to be taxed under the provisions of Subchapter S of the Internal Revenue Code) is also a pass-through entity. Thus, except in certain special situations, an S corporation pays no federal income taxes. The corporation's shareholders report their pro-rata share of corporate income, loss, deductions and credits on their own federal income tax returns. Unlike an LLC, however, an S corporation does not have the flexibility to make special allocations of these items.

The tax law places a number of restrictions on S corporations that may make electing S status unworkable for some businesses.

How Does an LLC Compare?

Limited Liability:

LLC - Yes

Corporation - Yes

S Corporation - Yes

Partnership - No

Limited Partnership - Only for limited partners

Federal Income Tax on Equity:

LLC - No

Corporation - Yes

S Corporation - No (some exceptions)

Partnership - No

Limited Partnership - No

Double Taxation:

LLC - No

Corporation - Yes

S Corporation - No (some exceptions)

Partnership - No

Limited Partnership - No

Allocations of Income/Expenses:

LLC - Yes

Corporation - No

S Corporation - Yes (pro rata only)

Partnership - Yes

Limited Partnership - Yes

Ownership Restrictions:

LLC - No

Corporation - No

S Corporation - Yes

Partnership - No

Limited Partnership - No

A Comparison of Commonly Used Terms


Although the precise legal definitions of these terms vary, they equate to one another in a very general sense as follows when used in the context of a limited liability company, corporation or partnership.

Who Owns the Business?

LLC: members

Corporation: shareholders

Partnership: partners

What Is Owned?


LLC: membership

Corporation: share

Partnership: partnership

Who Manages the Business?


LLC: managers or members

Corporation: board of directors and officers

Partnership: general partners

Document Creating the Entity:
LLC: articles of organization (in most states)

Corporation: certificate of incorporation

Partnership: partnership agreement or certificate of limited partnership

Agreement Detailing Specifics About Rights, Responsibilities, etc.:


LLC: operating agreement

Corporation: bylaws; shareholders' agreement


Partnership: partnership agreement

What Are the Potential Disadvantages of Operating an LLC?


Because the LLC is a relatively new form of business organization in the United States, it is as yet largely untested in the courts. The lack of established case law and uniformity may be viewed as possible disadvantages. Also, some tax issues remain unresolved.

Conclusion

The limited liability company is a welcome addition to the business organization menu that brings with it new planning challenges and opportunities. As use of the limited liability company becomes more widespread, we expect that most of the unanswered questions about it will be wholly or partly resolved. In turn, new issues may emerge.


As always, my firm is prepared to assist you in evaluating the best alternatives for you and your business.

This is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that it does not constitute legal, accounting or other professional service. If expert assistance is required, the services of a competent professional should be sought.