C-Corps vs. LLCs: Which One is Right for My Business?
When deciding the best way to structure their business, owners are often inundated with advice. And while friends , colleagues, and even accountants can mean well, they can inadvertently steer them into a choice that is problematic and expensive.
Take, for example, C-Corps vs. LLCs. Many sole proprietors and single-member small and medium companies assume that a simple Limited Liability Company (LLC) is sufficient for their needs. In some cases, they might be right. But an LLC that reaches a certain profit threshold, or an owner with several LLCs, can have a rude awakening at tax time. Often, a C-Corporation (C-Corp) ends up a better option with a lower tax rate.
If there is not something specific about a business that points to one structure over the other (for example, only C-Corps can take on investors and issue stock), how does a business owner decide? It requires a thorough understanding of several factors, including the company’s forecasted profits and losses, applicable tax rates, and an examination of the owners’ business portfolio as a whole.
The Difference Between C-Corps and LLCs
An LLC, or Limited Liability Company’s primary purpose is to shield a business owner (called a member) from personal liability in the case of a lawsuit. A settlement or judgment against the company would leave the member’s personal assets untouched.
From a taxation perspective, LLCs are pass-through or flow-through entities. This means that the company’s income passes through to the owner or owners. The entity itself pays no taxes. Instead, each member claims the income on their individual federal and state tax return. Members who work within the LLC are also subject to self-employment tax.
The tax designation of C-Corporation (or C-Corp) limits company owners’ liability like an LLC, but it is more complex, with additional requirements and capabilities. For example, C-Corps have to elect a board of directors and have bylaws, which is not required of an LLC. But, it can also offer fringe benefits to employees, something that LLCs are not allowed to do.
Most importantly, a C-Corp is a separate entity from its members with its own tax rate. The entity files a tax return and assumes the tax liability. Profits and losses do not pass through to anyone but instead remain with the entity. Shareholders and owners are only responsible for paying tax on the money they receive from the company. This is sometimes referred to as “double taxation”—the company pays tax on its income, and as shareholders, the individuals pay tax on their dividend income.
Tax Rates and Company Structure
A business owner’s tax bill can be significantly different depending on whether they classify their company as a C-Corp or an LLC. This is due to their different tax rates and how those rates are applied.
Since 2018, C-Corps pay a flat tax rate of 21%. Tax on profits of $400,000 would be $84,000 (21% of $400,000). If there are two shareholders, each person’s share would be $42,000. Any dividends received by the two would be included on their personal tax return at the dividend income tax rate of 15%. But with a C-Corp, there is no requirement to distribute dividends. For the sake of argument, let’s say each receives $20,000 in dividends. Taxed at 15% they would owe $3,000 plus the Corporate tax of $42,000, totaling $45,000.
As a pass-through entity, an LLC would pass that $400,000 profit on to the member(s), divided according to their percentage of the business. So, two equal partners would each claim $200,000 of income on their personal tax returns. A sole proprietor would claim the entire amount.
Marginal income tax brackets for individuals range from 10% to 37%. In the above scenario, the co-owners would each claim $200,000 in income, which in 2022 would be taxed at 24% for a tax bill of $48,000, more than if the business was a C-Corp.
It is also worth noting that LLC members must pay tax on profits whether they are distributed or not. Shareholders of C-Corps, on the other hand, only owe tax on the money they actually receive.
The following table summarizes the above examples:
|Net Business Income per owner||$200,000||$200,000|
|Income Tax Rate||21%||24%|
|Tax on Income||$42,000||$48,000|
|Dividend Tax Rate||15%||N/A|
|Tax on dividends/proceeds||$3,000||N/A|
|Total Tax Liability||$45,000||$48,000|
This is a simplified example. Many other factors come into play when preparing a tax return, including whether someone is single or married filing jointly. In the above example, 24% is the rate for a married taxpayer. A single filer with $200,000 in earnings is taxed at 32%!
Also, consider an LLC that yields income of $30,000. If the owner has a spouse with a salary of $175,000 which is near the top of the 22% tax bracket, this business income would nudge the couple into the next tier of 24%.
What it Means to Stack Pass-Through Entities
As our example shows, the tax burden for a C-Corp versus that of an LLC is a balancing act that juggles net income, the tax rates, and distribution decisions, along with everything else that impacts an individual’s tax return.
Making matters more complicated are business owners who “stack” pass-through entities. One small business LLC may not have much of an impact on an individual’s tax return. In fact, an LLC might be appropriate—if there is just one company. Problems arise, however, when additional LLCs are added to a business portfolio. Separately, the impact is small, but together, these stacked LLCs become costly at tax time. Converting LLCs to C-Corps can be a cost-effective remedy.
Which Entity is Best? Crunch the Numbers
When pass-through entities stack up, or even when one small LLC grows, a review of the tax implications is in order. Only by running the numbers and studying various scenarios can one see the impact of taxation at the Corporate tax rate versus individual tax brackets.
Too often, Swiecicki & Muskett meets owners of small and medium businesses and entrepreneurs who have received advice from well-meaning people who unfortunately have not looked at the big picture.
Luckily, it is never too late to convert an LLC to a C-Corp, if that proves to be the optimal strategy. We can begin by crunching the numbers to find the sweet spot to minimize your tax liability.