Do S corporations need to pay employment tax?

It is a common misconception that S corporation owners do not have to pay any employment taxes. This is because S corporations distribute earnings as a flow-through entity that are taxed in the current year and are not subject to self-employment tax. In fact, the IRS has ruled that the managing owner of an S corporation must pay themselves a salary that represents reasonable compensation for services rendered. The business must withhold payroll taxes just like any other paycheck received from an employer. It is only the remaining profits after salary expense that can be passed through as a distribution not subject to payroll taxes.

Should I create a C-Corporation?

The main reason on entrepreneur would want to become a Corporation is to raise capital because you want to issue multiple classes of stocks such as options and warrants to attract investors or you intend to sell your corporation in five years. Other secondary reasons to become a Corporation are because you have a foreign owner or you would like to take advantage of certain fringe benefits. The primary disadvantage to becoming a C Corporation is that there is a second level of tax on C corporation profits.

Should I create a limited liability company (LLC)?

There are two main reasons to become a limited liability company the first one is to protect your assets and the second is to legitimatize your business. Similar to a Corporation, the main advantage of an LLC is that it creates a legal structure around your business that makes it difficult for someone to sue you and obtain your personal assets as a result of a liability from the business. In fact, an LLC can offer better asset protection then a Corporation because it is easier to maintain the formalities of an LLC and if someone is successful in a lawsuit against you they can only obtain future profits interests, they cannot obtain shares in your stock as in a Corporation. LLCs also make an ideal structure to contain real estate investments.

The second reason to establish an LLC is to enhance the perception of legitimacy to your customers or to the public. Often times, a sole proprietorship does not convey to the public that a legitimate business venture is being undertaken. In fact many people believe that if you aren’t a Corporation or an LLC then you’re not legally a business. Although this is not true perception can be more important than reality for the small business that is trying to gain a foothold in their market.

It is important to note, that an LLC does not change your tax status. That is, an LLC can be a sole proprietor, a corporation, or a partnership. This is why they call the LLC a wrapper. Because it just wraps and protects business entity that’s inside the LLC, it does not change the tax status of of the business. Once you are in an LLC you can pick and choose however you would like to be taxed; a sole proprietorship a Corporation or even an S Corporation can all be LLC’s.

Should I create a partnership?

A partnership is similar to a sole proprietorship, except you are running the business jointly with somebody else. What is misunderstood about partnerships is how easy it is to become one. As soon as you shake hands and decide to make profits together, you become a partnership. In fact, your children’s lemonade stand is a partnership that should file a partnership tax return. The partners to a partnership will also pay self employment tax on their share of the income generated by the partnership.

What is great about a partnership is that it is a very flexible entity. Oftentimes, when two or more people get together to start a business, it is unclear as to who will make the greatest contributions, do the most work, or bring in most of the business. In fact, it is common that the performance of a partner is not quite what was expected which leads to problems in the business. The partner you thought was wonderful becomes something very similar to a messy roommate. Partnerships can be structured so that even under a 50-50 profit split arrangements, a disproportionate distributions can be taken from the partnership to compensate partners for their contributions that are inconsistent with the original 50-50 agreements. These disproportionate distributions are impossible under an S Corporation arrangement which is quite common structure for new entrepreneurs to use. S corporations and C corporations must make profit distributions according to the number of shares owned by each owner.

How important is it for the new entrepreneur to pick the right entity structure for tax purposes?

The first thing to understand about this decision is that even if you’ve done nothing, by the mere fact that you are engaged in a business you are already a sole proprietorship. In tax this is known as your default classification. The reason that this is important is that from a tax perspective your classification is already determined and you do not need to worry about getting the entity structure rights before you start your business.

A sole proprietorship is filed on your schedule C of your form 1040. It tracks your revenue and expenses from your business and arrives at a profit. This profit is taxed at self-employment tax rates of 13.3% in 2012. This self-employment tax is in addition to your income tax. These taxes replace the employment tax deductions that are taken out of your paycheck. Employment taxes include Social Security and unemployment taxes. Self-employment taxes become a problem after profits are being generated in your business and changing your structure to optimize taxes become important after you are making at least $50,000 in profit in your sole proprietorship. As long as profits are low, the sole proprietorship offers an easy, flexible, low-cost, structure for your business.

What type of entity should I choose, LLC, C corporation, or S corporation?

Deciding whether you should organize as a C corporation, S corporation or limited liability company can soak up a lot of time and resources.  Some founders may spend more time on this question than is warranted given the inability to know for sure how quickly your business will grow, how much and which type of outside investment will be required, whether cash will be reinvested or distributed to owners, or whether you will sell the Company or go public – all of which are part of the analysis.  Tax rules are the primary source of the complexity, although management and liability issues under state law also make a difference.  

Founders tend to fall into two categories when dealing with this issue – those that , with their lawyers and accountants, carefully analyze the various tax rules against their expected growth and exit strategy and try to make the best decision under uncertainty  – and those that punt, opting to stick with the format used by most VC-backed technology companies  (C corporation) and spend their time and energy on growing their business.  

One reason venture capital firms generally will only invest in corporations because they usually have tax exempt investors who do not want to subject to unrelated business income tax (UBIT), which would be an issue with an LLC.  Moreover, VC members may not want to file state tax returns, or, in the case of foreign investors, federal tax returns.   VCs like some of the other advantages to C-corporations discussed below.   

For those that want to dive into the analysis, I discuss the major differences between C corporations, limited liability companies, and S corporations in the second half of this article.   Perhaps the best place to start the  analysis is to understand why most tech startups are corporations, and to consider what makes your company different, if anything.  If not, you may want to follow that model.   Since the C corporation is the predominant entity form for tech startups, documentation has become fairly standardized for corporate governance, rights among shareholders, equity compensation, and capital raises. 

The top level questions that will affect your choice of entity are these:

  1. Do you expect to take money from a Venture Capital firm or an institutional investor.   In this case, you will need to be a C corporation, although you may be able to start life with an S election while you bootstrap and only convert if it becomes necessary.
  2. Will you be a typical technology company that will want to issue stock options to employees, raise capital through preferred stock, and expect a typical technology company life-cycle in which all surplus will be reinvested into the company (no distributions to owners) which is grown until the company is acquired or goes public, These factors would push you toward the C corporation form.
  3. Alternatively, will your company be operated for its cash flows over a long period of time, not necessarily managed for a public exit.   In this case, a pass through entity such as an LLC or an S corporation may be preferable.

Those are the primary considerations.  For those that want to dig deeper into the minutiae, what follows is a more detailed discussion of the differences between C corporations, S corporations, and LLCs (taxed as partnerships). 

C Corporations.  The biggest downside of corporations is that they are subject to double taxation.  (The corporation itself is taxed on its profits, and shareholders are taxed when earnings are distributed to them.)   However, the downside is diminished if the company intends to reinvest most of its surplus cash for growth.  Moreover,  the C corporation can accumulate net operating losses, which may offset profits in the future or have value to an acquiring corporation.  C corporations can qualify for Section 1202 qualified small business stock, and for Section 368 tax-free reorganizations.

Limited Liability Companies.  Technically, LLCs are disregarded entities in the eyes of the IRS.  Under the Code, LLCs may elect to be taxed as a partnership, as a C corporation, or as an S corporation.  When people refer to the tax treatment of LLCs, they usually mean an LLC that has elected to be taxed as a partnership.  Taxed as a partnership, the LLC is a “pass-through entity” that is not taxed.  The members are taxed according to the amount of profits that are allocated to them per the terms of the operating agreement.  Allocations of profits and losses need not necessarily follow ownership percentages, they can be specially allocated per the terms of the operating agreement, although accounting and compliance gets more complicated when it does not.  Investors can offset their other income from their share of LLC losses.  Another advantage of partnership taxation is that appreciated assets  can generally be distributed to partners/members tax free.  (This can allow tax-free spin-offs of subsidiaries and other assets to the members.)  Appreciated property (such as developed software, for instance) can be contributed to the LLC tax-free (without a  “control requirement”).  Lastly, redemptions of membership interests are a deductible expense to the LLC.

S-Corporations.   Technically an S corporation is an election filed with the IRS, not a form of entity.  LLCs, as well as corporations can be taxed as an “S corporation”.  An LLC that makes an S election will be an S corporation in the eyes of the SEC, but it’s corporate governance matters will still be controlled by state law and the LLC operating agreement.  Like an LLC taxed as a partnership, an S corporation is a flow though entity with a single layer of tax.  S corporations convert easily to a C corporation.  (Actually they convert automatically to a corporation if the company does anything to blow its S election, such as exceed 100 shareholders, accept a foreign shareholder, or issue preferred stock.)  As with C corporations, Section 368 tax-free reorganizations are available. 

 An S corporation structure may result in the reduction in the overall employment tax burden.  One difference between S corporation taxation and partnership taxation is that owners of LLCs can not be employees of the company.   All member draws are subject to self-employment tax.  With S corporations, owners may be reduce employment taxes by taking part of their income in salary (and paying employment taxes on that) and taking the rest of their income as a distribution.  S corporation shareholders who are employees are taxed as employees and receive a Form W-2, not a Form K-1.   As long as the salary is reasonable in the eyes of the IRS, the income taken as a distribution is not be subject to employment tax withholding. 

Traditional stock options are available for S corporations, as long as the exercise price is a fair market value and doesn’t have any unusual terms that would cause it to be characterized as a another class of stock. 

In summary , here are reasons you may choose one entity form over another:

 C corporation because:

  • Predominant model for tech start-ups (equity offerings and IPOs)
  • VCs usually won’t invest in LLCs
  • You will have foreign, corporate, or non-profit investors
  • Retention of earnings/reinvestment of capital
  • Qualified small business stock (Section 1202)
  • Section 368 tax free reorganizations available

LLC (taxed as partnership) because:

  • Single level of tax
  • Flow through entity that allows: multiple classes of units, foreign members, over 100 members
  • Investors can use operating losses
  • Business will be operated for cash flows
  • Tax-free distributions of appreciated assets
  • Tax-free contribution of appreciated property without “control requirement”
  • Special allocation of tax attributes (such as specific gain, loss, income or deductions)
  • Redemption of partnership interests are deductible expenses of the LLC

S corporation because:

  • Simple flow through entity with single level of tax
  • Easy to convert to C Corporation
  • Can minimize employment taxes
  • Investors can use operating losses
  • Business will be operated for cash flows
  • Traditional stock options are available (as long as exercise price is at market value)
  • Section 368 reorganizations available

But, S corporations are limited to 100, domestic, non-corporate shareholders, one class of stock.  Shareholder redemptions are not deductible.  Lack of ability to allocate profits, losses, attributes other than pro rata.