Detect accounting fraud, invest safely.

In my previous post, I talked about the four ownership structures available to choose from. Eliminating the ownership structures that don’t provide limited liability protection, I’m left with two choices: a limited liability company (LLC) and a corporation.

LLC Tax Implications

If you recall from Part 1 of this series, owners of LLCs are called members. An LLC can have one or many members. Because LLCs are treated as pass-through entities, income (or in LLC lingo “guaranteed payments”) to member managed LLCs are taxed as ordinary / earned income to members. What’s important here is that each member is treated as an employee. For those of you who are not familiar with self-employment, being self-employed certainly has its perks. But it also has its fair share of drawbacks. Self-employment taxes, for one, ends up doubling your tax bill. Here’s an example:

I am a managing member of Qovax, LLC and am involved in day-to-day operations. IRS will treat me as an employee. As an employee, I will have to pay 7.65% in taxes (6.20% social security and 1.45% medicare) on my portion of the income. But since I am also a member of Qovax, I am self-employed. Employers pay the same amount of social security and medicare taxes that are deducted from employee paychecks. So I end up paying 15.3% (7.65% x 2) of employment taxes. Ouch.

The observant reader will notice that one can avoid the self employment tax by making a distribution to members at quarter or year end instead. This will work only if the member receiving the distribution is a passive member in a manager managed LLC, that is someone else has to run the company for you. A passive member cannot be involved in day-to-day operations. Following this, it is only logical that the member contributes her share of capital in exchange for ownership in the LLC. Otherwise, it is easy for the IRS to choose to treat her as a member who earned her ownership stake from services rendered to the LLC. Thus, she will still be liable for self employment tax. Hence, it is crucial to document members’ capital contributions to the LLC in the operating agreement.

Corporation Tax Implications

With a corporation (both S and C), you would still pay the same 15.3% in employment taxes. But a corporation provides the ability to split your income. What this achieves is a potentially lower income tax rate. The table below outlines the 2007 corporate and individual income tax rates

Note that a corporation pays a lower tax on the first $75,000 of income when compared to a couple. If your corporation earns under $75,000, by retaining more income at the corporation level and paying less salary to yourself, you stand to pay lower taxes on the bigger retained income amount and higher taxes at the smaller personal income amount. This advantage vanishes once your corporation earns more than $75,000. So choosing the corporation structure based on this factor alone may prove unwise unless you expect your business to stay stagnant once it hits $75,000 in income.

In the past, a corporation used to afford the owner more fringe benefits compared to an LLC owner. For instance, you can deduct self-insured medical reimbursements, 100% health insurance, life insurance and dependent care premiums. But beginning in 2003, health insurance is also fully deductible for LLCs that are taxed as partnerships. As such, the advantage in fringe benefits that a corporation has over an LLC has narrowed significantly.

The double taxation is a double edged sword; it can reduce your taxes if your corporation earns less than $75,000 as discussed above, but after $75,000 your taxes increase significantly. As an owner of a corporation, the owner is taxed at the corporate level and then again when a salary or dividend is paid to the owner. The current 15% tax on qualified dividends is what Warren Buffett would call a rich man’s tax. The wealthy tends to earn the majority of their income from investments. This form of income is known as passive income. Qualified dividends and capital gains are taxed at 15% while average wage earners are usually taxed at an effective rate of 30%. If you really hate to pay double tax, there is an alternative - an S Corporation.

An S Corporation is much like an LLC. It is basically a corporation treated as a pass-through entity. What that means is you don’t pay taxes at the corporate level, only at the personal level. Of course, that also means you don’t get the benefit of a 15% qualified dividend tax. Income to an S Corp, whether it’s distributed or not, is subject to your normal income taxation minus the employment taxes. But resist from salivating over the 15% tax rate for C Corporations. You only get the 15% tax rate after your C Corporation has paid its taxes on the dividend you are distributing to yourself.

So how is the S Corporation different from an LLC? The paperwork and, depending on which state your business is incorporated, the state taxes. I live in California, where the mild weather, sunny days and beautiful beaches don’t come free. In California and several other states such as Texas, an LLC also pays a state franchise tax. The Franchise Tax Board (FTB) of California levies an annual $800 minimum franchise tax on LLCs. In short, you pay $800 a year regardless of whether you make a profit or not. This gets even better if your LLC earns more than $250,000 in revenue. An LLC in California is taxed based on its gross receipts! Although this LLC fee has been declared unconstitutional by the San Francisco Superior Court in a recent case, you are still required to pay the fee annually until the tax code is changed. You could file a protective claim for a refund on the taxes you paid but due to its pending nature, I’m not sure I want to play that game.

Of course, since the S Corporation structure has been around longer than the LLC has, the CA FTB has long implemented a similar minimum tax of $800 for S Corporations. The good news is the similarity ends there. An S Corporation is taxed on the greater of $800 or 1.5% of net income at the corporation level annually. Plus, first year S Corporations are exempted from paying this $800 minimum tax.

Comparing LLC and S Corporation

If you are running a high revenue, high pre-tax margin (income after all expenses before taxes as a percentage of gross revenue) business, you would be paying less tax with an LLC. On the contrary, you will pay more tax on a high revenue, low pre-tax margin business. To illustrate, an S Corp with 20% pre-tax margin on $1 million revenues will pay $3,000 in taxes. An LLC, on the other hand, will pay $6,000. But if your pre-tax margin is, say, 50% on $1 million of revenues, an S Corp will pay $7,500, while an LLC will be paying $6,000. To put this into perspective, Microsoft earns a five-year average pre-tax margin of 38%. Once your pre-tax margin exceeds 40%, you will likely save on tax going with an LLC as long as the current LLC tax on gross receipts remain in place. Having said that, considering the aforementioned supreme court ruling, I wouldn’t bet on the survival of this benefit for too long. It’s unlikely that a startup earns that much in revenue in first few years. If it does, and the tax code for LLC survives the supreme court ruling, an LLC may be your best bet. For now, S Corp seems like a better choice to me. Don’t forget that you can convert to an LLC later should you find yourself in the “unfortunate” event that your company is becoming too profitable.

The laws governing an LLC are still evolving and probably still have a long way to maturity. Importantly, the Federal tax code (PDF) does not have an equivalent ownership structure for LLC. A multi-member LLC can elect to be treated as a corporation or a partnership. A single-member LLC can elect to be treated as a corporation or sole proprietorship. If you do not file Form 8832 (PDF) to elect to be treated as a corporation, the IRS will treat a multi-member as a partnership and a single-member as a sole proprietorship for tax purposes (the liability protection remains intact). This begs the question, “Why choose an LLC if you are going to elect an underlying tax entity that is not an LLC?” The answer, some say, lies in the next few topics I will talk about. First, let’s look at what it costs to register and maintain an S Corp and an LLC.