Tim Gillis, Attorney at Law firm GILLIS WAY & CAMPBELL was recently interviewed for his knowledge and experience on how to choose a business entity. Get important information and tips on business entities and their tax advantages from a legal standpoint.
Q: What advice would you give before forming a business?
GILLIS: There is really a series of questions that I would ask. First, What type of industry is the business going to be?
Certain industries or activities lend themselves to tax classification. If you are going to be investing in real estate, for example, I am probably going to recommend an entity taxable as a partnership; not an S corporation, but a partnership. In this example, I am probably going to push you towards an LLC.
If you are going to be an operating business or an owner operator, such as a law firm, marketing agency or something like that, then I will recommend something that is taxed as an S corporation. There is a reason for that. They call it the “S corporation tax loophole.” It is not really a loophole, it is the industry and we can talk about that more. So what is your industry?
The next question I will want to ask is, Who’s going to run the business; who is going to own it?
If you have an LLC, you are going to have an operating agreement between you and your co-owners. If you have a corporation, you are going to have a shareholders agreement between you and your co-owners. There are rules applicable to each depending on whether you can make special allocations of income. You cannot really do that with an S corporation but you can do it with a taxable partnership entity.
Q: What are the tax advantages of an LLC versus an S Corporation?
GILLIS: In reality, we are talking about the tax advantages of an entity taxable as an S corporation or an entity taxable as a joint partnership, and the partnership assumes you have more than one member. Typically, they both have pass through taxation.
The entity itself is not going to pay income tax. It is going to file a tax return and will issue its owner a K1. Then the owner is going to include that owner’s allocated share of taxable income on their personal tax return and pay tax at that level — one level of tax, generally speaking. There are some special S corporation exceptions. That is good and it is why you do not want your entity to be a C corporation because a C corporation can have double taxation.
Beyond that, it depends a lot on the activities of the business. With S corporations the owner, who also works in the business, needs to pay themselves a reasonable salary. So I tell people that a reasonable salary is what you would have to pay someone if you were to hire them to do your job in the business and on that salary, you are going to pay your employment taxes.
Anything over and above that, the company makes you take out as a distribution. It is profit and is not going to be subject to employment taxes. So your reasonable salary is what you are going to pay your employment taxes on. Anything over and above that, you will not pay employment taxes on. That is what people refer to as the “S corporation tax loophole. It really is not but it makes a good sound bite.
On the partnership side, if you are a partner in a partnership and you are working and taking money out as distributions, you are going to pay the employment taxes on every penny. That is the difference. On the flip side, if you are going to be depreciating, take a lot of tax deductions, or if you want to make a lot of special allocations and will be borrowing money to acquire assets, a partnership might be something you want to look at. It is sometimes a little easier to take those tax losses on your personal tax return as opposed to if it was an S corporation.
Q: Is an LLC a good choice?
GILLIS: Yes, for a small or mid-size business. If you are a sole owner, it is not going to matter a lot whether your corporation pays taxes as an S corporation or as an LLC. If you want to report it on schedule C on your individual tax return, you will want an LLC rather than a state law corporation.
If you want to be an S corporation, you can go for an LLC or a state law corporation and if it is not a multi-member type of operation, you get about the same level of protection from creditors. In Florida, owners of the company are not liable for the obligations of the business just by virtue of owning the business. An LLC can work; there is no reason not to have an LLC.
Q: Which is better — an S Corporation or an LLC?
GILLIS: An LLC is a type of entity. An S corporation is a tax classification, not a type of entity. They are two completely separate things.
What most people ask is, Should I have an entity that is taxable as an S corporation, as a partnership, or as a disregarded entity?
You have to make a tax election and then you have your choice of entity (what type of entity are you going to form). You can form a state law corporation, which then makes an S election becomes an S corporation or defaults as a C corporation, which you probably do not want.
Alternatively, you can form an LLC. If it is a single member LLC, the default basic rule is that it is going to be disregarded for tax purposes. You can make an election and you can elect to have that LLC taxed as something other than a disregarded entity. You can make an S election for your LLC.
Similarly, if you have a multi-member LLC, the default rule is that it is taxed as a partnership for tax purposes However, you can make an election and have it taxed as an S Corporation for tax purposes.
Q: What are the top reasons to choose a C Corporation?
GILLIS: A C corporation is rarely something we recommend to a small business client. I cannot really even think of a good reason to choose a C corporation.
If you are a foreign entity coming into the United States and are going to have a holding company in the U.S., then that is going to be a C corporation, for certain reasons.
If you are some type of large business, such as being publically traded or if you have a significant number of shareholders, you are going to be a C corporation.
But if you are an operating business or an investment partnership, or something along those lines, there really is not any good reason to go with a default tax classification. There are some here and there but typically you do not.