They way you structure your business can greatly affect your tax liability. In the eyes of the IRS, there are two main types of business entities: limited liability companies (LLCs) and corporations. If you’re thinking of setting up a business or are thinking of converting your business entity structure, it’s important to understand the differences in how LLCs and corporations are taxed. This will allow you to understand what your business may qualify as and, additionally, help you choose the most advantageous structure possible.

To help you gain a better understanding of which entity structure may be right for you, in this post we’re taking a closer look at how LLCs and corporations are taxed. Read on to see our Business Taxes 101 Guide: LLC vs. Corporate Taxes Edition.

Corporation Taxes

For federal tax purposes, there are two types of corporations: C corporations and S corporations. By default, all corporations will start out as C corporations. Then, some corporations can elect to be taxed as S corporations. Whether your business is classified as a C corporation or an S corporation by the IRS does not have any impact on how you run your business. However, it does have an impact on how you are taxed by the IRS.

C Corporation

If your business is a C corporation, both your corporation’s profits and any distributed profits to shareholders will be taxed. Because C corporations are taxed at two different levels, C corporation taxes can often be higher than S corporation or LLC taxes.

S Corporation

An S corporation is known as a pass through entity because an S corporation’s profits will pass through to shareholders and be taxed as personal income tax. If your business is an S corporation, the corporation’s profits are not taxed before distribution, like they would be if your business were a C corporation.

Electing to be taxed as an S corporation can be advantageous for many types of businesses, since it can sometimes lower overall tax liability. However, not all businesses can elect to be taxed as an S corporation. There are five IRS requirements that must be met to elect to be taxed as an S corporation:

– You must be a domestic corporation.

– You must have only allowable shareholders. Allowable shareholders can be individuals, certain trusts, or certain estates. They may not be partnerships, corporations, or non-resident alien shareholders.

– You must have no more than 100 shareholders.

– You must have only one class of stock.

– You cannot be an ineligible corporation. Some ineligible corporations include certain financial institutions, insurance companies, and domestic international sales corporations.

Corporation Employment Taxes

If a corporation’s shareholder works in the business of the corporation, they will be considered an employee and should be salaried. In this case, the corporation will pay half of their shareholder employee’s Social Security and Medicare taxes and withhold the other half from their salary, as any business owner is required to do for their employees.

While a shareholder’s salary is subject to Social Security and Medicare taxes, their profit dividends are not. So many shareholders take advantage of this by taking a lower salary and a higher amount in distributions, which can help their overall tax liability amount. However, to avoid abuse of this tax law, the IRS does require that shareholder employees be paid a reasonable amount for their salary. So if you are a shareholder employee, you do need to mindful that you must be paid a reasonable amount as your salary to avoid getting into trouble with the IRS.

LLC Taxes

Limited Liability Corporations (LLCs) are a relatively new type of business entity. And as of 2019, there is no single way LLCs are taxed. Those who have an LLC instead must choose between three different tax classifications, which gives LLCs some flexibility in terms of how they are taxed. There are three ways an LLC can be taxed: as a disregarded entity, as a C corporation, or as an S corporation.

LLCs as Disregarded Entities

The default classification for an LLC is the disregarded entity classification. With this tax classification, LLCs are taxed like sole proprietorships, wherein the business’s income and expenses pass through to the LLC owner’s personal tax return. The main difference between an LLC that is a disregarded entity and a sole proprietorship is in potential personal liability for a business’s liabilities. Under a sole proprietorship, the business owner has no protection against being personally liable for their business’s debts or legal liabilities. Under an LLC, there is some personal liability protection for a member of an LLC (hence the name of this business entity type), since the LLC is a separate business entity.

LLCs as C Corporations

An LLC can choose to be taxed as a C corporation by filing form 8832 with the IRS.

LLCs as S Corporations

Provided that an LLC meets the qualifications for being taxed as an S corporation, an LLC can elect to be taxed as an S corporation by filing form 2553 with the IRS.

LLC Employment Taxes

LLC employment tax rules depend on which classification the LLC is under. If an LLC is taxed as a disregarded entity, they pay the same type of employment taxes as a self-employed person would. Self-employed persons must pay both the business owner’s half of their Medicare and Social Security taxes and the employee’s half. Then, an LLC that is taxed as a corporation would follow corporation employment tax rules (which are outlined in the above “Corporation Employment Tax” section).

Final Thoughts on LLC vs. Corp Taxes

Whether your business would be best served as an LLC or a corporation can depend on a vast number of factors. And then, of course, which type of LLC or corporation would best serve your business can also vary widely depending on your unique business structure.

If you aren’t sure what type of business entity would be right for your business, it’s a good idea to hire a tax professional to receive professional tax planning advice. A tax professional can examine your new or existing business’s finances and structure to help you determine which type of entity would be most advantageous for your business.