Federal Taxation of Startup Business Entities
Updated: Mar 24
When entrepreneurs ask which business entity to use for their startups, one of the main considerations is limiting liability. The most common types of business entity format are the corporation and the limited liability company (the “LLC”). Because both corporations and LLCs limit the liability of their owners, a second consideration comes into play: Which entity is better from a federal taxation perspective? This post examines the pros and cons of each entity.
The IRS has two systems of taxation for businesses. In one system, the business pays taxes on its earnings. In addition, whatever profits the business pays its owners is taxed to them individually. By default, corporations are taxed this way.
Under this system, there is a potential for double taxation. Small businesses can avoid double taxation by paying out nearly all the business’s money to the owners at the end of the fiscal year. That way, there is nothing much to tax at the entity level. But at other times, for various reasons, the business must leave money in its bank account, and it is taxed.
The other system of taxation is called “pass-through” taxation. What this means is that the business, as an entity, is ignored for tax purposes. Everything the business makes is “passed through” to the individual owners. The owners pay taxes on their shares of the business’ income. The business itself pays no taxes. This system of federal taxation is the default for LLCs.
When a corporation is organized, it becomes a “c” corporation. Nobody knows why “c” corporations are called “c” corporations. But what “c” status means is that the corporation is taxed at the corporate level. The corporation pays taxes. Dividends to shareholders, who are the owners, are taxed to them individually. There can be double taxation.
Like any set of rules, there are exceptions. One of them is the difference between the “c” and the “s” corporation. Under certain conditions, a corporation can elect to be taxed as though it were a “pass-through” entity. These corporations are called “s” corporations because the election is contained in Subchapter S of the Internal Revenue Code.
Although the “s” corporation election is simple, and routinely granted, it can be used only in specific circumstances. Some of the requirements are that (1) the shareholders must be individuals, certain trusts or estates (not partnerships, corporations or non-resident aliens); (2) there must be no more than 100 shareholders; and (3) there must be only one class of stock (for example, no “preferred” stock, which means that preferred stockholders would be paid dividends before the rest of the stockholders).
By default, corporations are subject to double taxation because they are “c” corporations unless they opt for “s” status. LLCs are exactly the opposite: By default, they are considered “pass-through” entities. There is no taxation at the entity level. Income is passed through to the owners of the LLC who pay individual taxes on their share of the LLC’s income.
As with corporations, LLCs can elect to be taxed otherwise. They can file with the IRS to be taxed like “c” corporations – in other words, federal income tax is imposed at the entity level, and also at the owner level, on LLC income. There are no restrictions on an LLC electing to be taxed like a corporation. For example, there can be more than 100 LLC owners, unlike an “s” corporation.
Congress passed the Tax Cuts and Jobs Act (the “TCJA”) in late 2017, effective January 1, 2018. This statute included substantial changes to the federal taxation of corporations and LLCs.
The federal corporate income tax rates used to be graduated. “C” corporations with taxable income of no more than $50,000 per year were taxed at 15%. At over $50,000 of taxable income, the rates fluctuated, from 25% to 39% and ultimately back down to 35% for taxable income of $18,333,333 and up. The TCJA did away with the graduated tax schedule. The federal income tax rate for all “c” corporations is now a flat 21%.
If a “c” corporation is newly organized and has taxable income of $50,000 or less, the TCJA does it no favors. The federal taxation rate was 15% but is now 21%. On the other hand, once the corporation’s taxable income exceeds $50,000 per annum, the TCJA does cut the tax rate substantially.
The TCJA also made a change to how LLC income is taxed to the owners of an LLC. The TCJA did not change the fact that LLCs are pass-through entities for tax purposes. The income of the LLC is still passed through to the owners and taxed at the owner’s personal income tax rate. But now, up to 20% of the pass-through income from an LLC can be excluded from the owner’s individual tax return if the LLC is in a professional line of work and has employees. Thus, an LLC owner can receive as much as a 20% discount on the amount of LLC income taxed to the owner.
This 20% exclusion applies when the LLC’s main asset is the skill or reputation of the owners or employees. Examples are lawyers, accountants and financial services firms. When this is the case, and the LLC also pays wages to employees, there can be up to a 20% exclusion of income for single taxpayers with no more than $157,000 in taxable income and $315,000 in taxable income for married taxpayers filing jointly. The 20% exclusion decreases after these levels of taxable income are reached. It vanishes entirely once a single taxpayer hits $257,000 in taxable income and a married couple filing jointly hits $415,000 in taxable income.
The answer to this question, as to so many, is “It depends.” But in the startup world, often a business runs at a loss for a while, so the LLC might be better from a tax perspective. Losses, like profits, pass through to the owners of the LLC.
As the business prospers, and seeks outside capital, most savvy investors will request conversion to a corporation because corporate law is much more developed than LLC law. Investors like to reduce risk as much as possible, so they prefer the corporate format. The conversion would be to a “c” corporation unless the LLC owners met the test for “s” status, in which case the converted corporation could elect “s” status. Taxwise, if the new “c” corporation qualified as an “s” corporation, the owners could achieve the same pass-through result as with an LLC.
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