Business Entity Basics Part II: Corporation vs. LLC – Taxes Matter

By Andrew Randol - January 12, 2019 - Corporate & Business

In Part I of Business Entity Basics, our Columbus business law lawyer explained what a business entity is and why you need one. In case you missed Part I, it is almost always best to choose a limited liability entity, such as a corporation or LLC, over a non-limited liability entity, such as a partnership. Owners of limited liability entities are generally not personally liable for the debts of the entity. Thus, limited liability entities provide a financial shield against the losses of the business.

In Part II of Business Entity Basics, our Columbus business attorney will focus on how to choose between the two primary limited liability entities in Ohio: the LLC and the Corporation. While there are many differences between these two limited liability entities, most entrepreneurs rightly focus on their bottom dollar. In this sense, taxation is the most significant difference between the LLC and the Corporation. To sum it up in one sentence, generally, corporations are taxed twice and LLCs are taxed once.

C Corp Taxation

When corporations earn a profit, they are taxed under the corporate tax rate. With the passage of the Tax Cuts & Jobs Act of 2018, corporate profits are taxed by the federal government at a flat rate of 21%.

However, corporate profits are taxed a second time as income when they are distributed to the shareholders as dividends. Most dividends are considered ordinary dividends and are taxed as ordinary income. In some instances, dividends can be considered qualified dividends, which are only subject to capital gains taxes.

For example, if a two-shareholder corporation earns $100,000 in profits, the corporation itself will be faced with a 21% tax of $21,000. If the corporation then distributes the remaining $79,000 equally between the two shareholders, then each shareholder pays income taxes on their share, unless the dividends can be considered qualified dividends which are subject to the capital gains tax.

LLC Taxation

While LLCs can elect to be taxed as a corporation, most LLCs are taxed as a partnership. It is important that you do not confuse federal tax law with state business entity law. The federal government has never passed something called an LLC tax after LLCs became common place in the 1990s. Thus, LLCs essentially rely on forms of taxation that existed prior to their creation.

Under a partnership form of taxation, profits and losses are passed directly to the owners; the entity itself does not pay taxes on income. Under partnership taxation, each partner (or in the case of an LLC, each member) pays taxes on their distributive share. Usually, each partner’s distributive share is equal to their ownership percentage in the company.

For example, if a two-member LLC earns a $100,000 profit and each member owns 50% of the company, each member will pay income taxes on $50,000 of those profits. It is important to note that a distributive share for tax purposes can be different than the amount of cash each partner actually receives. For instance, most companies opt to leave some money in the bank for a rainy-day fund to cover future expenditures.

In the example above, if the two-member LLC leaves $20,000 of its profits in the bank and distributes the other $80,000 in cash between the two members, each member still pays income taxes on $50,000, even though each only received $40,000 in distributions.

A single-member LLC essentially operates in the same way. The distributive share is always passed through to the single-member for tax purposes.

Which is Better?

Most small businesses benefit from being taxed as a pass-through entity, rather than a corporation, simply because they avoid double taxation. This does not mean that all businesses should elect to be taxed as a partnership. Companies that plan on seeking venture capital or plan to become a publicly traded company would likely elect to be taxed as a corporation. However, this is a more advanced topic that will be reserved for a later article.

The S Corp Wrinkle

The partnership form of taxation is not the only form of pass-through taxation. The small business corporation, or S Corp, is another pass-through tax election that can be made by both a corporation or an LLC. However, one small difference in the law allows S Corp owners to potentially save on self-employment taxes. The S Corp’s benefits and limitations will be the subject of Business Entity Basics Part III.

It is important to note that this article is meant to be a general discussion of the topic. In reality, choosing the right business entity is much more nuanced and should be discussed with a competent Columbus business attorney. A good Columbus business lawyer must take into account a broad range of facts that differ from business to business. Contact our to discuss how our business law firm can help you choose the right entity and prepare the legal documents to get your business up and running.