Grappling with the complexities of taxation on a small business? As strange as it may sound, your Limited Liability Company could opt to be taxed as a C corporation – a decision that could tilt your financial scales favorably.
No matter your circumstance as a small business owner – desire to minimize self-employment tax, seek potential venture capital, or better manage business expenses, opting for C corporation taxation could unlock these benefits and more for your Limited Liability Company.
However, as we’ve seen numerous times from our position as tax professionals and business owners ourselves, this path is not devoid of complexities.
Let’s delve into the fray, dissecting the elements of C corporations, from taxable income to classification and more.
Brief Overview
- An LLC can elect to be taxed as a corporation, which brings numerous benefits, such as unlimited shareholders, no constraints on shareholder qualifications, and an array of tax deductions.
- Despite the advantages, there are also drawbacks, such as additional reporting requirements and complex tax compliance.
- Deciding to switch the way your LLC is taxed should be carefully considered, taking into account both the benefits and complexities it involves.
What Is a C Corporation?
A C Corporation, commonly referred to as a C corp, is a type of business entity in the United States. It’s distinct because it regards corporate taxes separately from its owners’ personal taxes. A C corp issues stocks, raises investments, and enjoys significant tax advantages.
Nevertheless, a prominent disadvantage is the possibility of double taxation – where profit is first taxed at the corporate level and once more when disbursed to shareholders as dividends.
Additionally, C corporations are subject to more regulations and stricter compliance requirements than simpler structures such as sole proprietorships, partnerships, or Limited Liability Companies.
How To Have Your LLC Treated as a C Corporation
Switching your tax status from an LLC to a C corporation for taxation purposes can seem daunting. However, we’ve broken down the process into digestible steps.
Step 1 – Verify Eligibility: Your first task is to ensure that your LLC qualifies for a small business corporation status. Generally, your LLC is eligible if it does not have more than one class of shares, which is typical for most LLCs. The Internal Revenue Code states small business corporations are only eligible if their shareholders are individuals, estates, or certain trusts.
Step 2 – Obtain an EIN: You need an EIN to pay taxes. It’s the equivalent of an individual’s social security number. If you already have one, you can skip this step. If not, you can get it from the IRS for free, either online or by post.
Step 3 – File IRS Form 8832: This is where you make the entity classification election. You’ll need to complete IRS Form 8832 to indicate that you want your LLC to be taxed as a C corporation. Ensure your form is accurate to avoid any legal entity contradictions that could complicate your tax status.
Step 4 – Submit Form 8832: Once you’ve completed the form, submit it to the IRS. The agency will then evaluate your status change. Approval typically takes six to eight weeks.
Step 5 – Notify State Authorities: Finally, inform your state’s tax department about your new corporate status. Each state has different requirements, so it’s crucial to understand the tax implications specific to your location.
An inside tip we can provide is to always check the corporate tax rate against the personal income tax rate. Sometimes, the corporate rate can be lower, and choosing to be regarded as a C corp can save money in the long run.
Benefits of an LLC Taxed as a C Corp
Before diving into the distinct advantages, it’s essential to remember that every business is unique. While the benefits listed below generally apply, the decision to opt for C corp taxation should be tailored to your specific circumstances.
No Limit on Shareholders
A major benefit is that there is no limit on the number of shareholders a C corporation can have.
This overcomes the restriction faced by S corporations, which cannot have more than 100 shareholders. This can significantly aid growth, as a C corp can attract a larger pool of investors.
From our experience, this often leads to the accumulation of more capital, which can be a game-changer for expanding your small business.
No Constraints on Shareholder Qualifications
Unlike S corporations that limit ownership to US citizens or residents, a C corp can have foreign shareholders. This lack of restriction widens the potential base of investors, boosting your ability to raise funds.
This is especially advantageous for businesses targeting global growth. According to Deloitte’s 2020 survey, 75% of companies operating international businesses reported increased revenue, further highlighting the potential advantages of a global investor base.
Ability to Raise Funds and Go Public
A C corp taxation structure offers better fund-raising capabilities and the opportunity for LLCs to go public. This ability makes it viable to raise large amounts of financing and can fuel exponential growth.
For instance, Amazon, a classic example of a C corporation, raised $54 million in its initial public offering in 1997, according to The New York Times, offering a glimpse of the capital-raising power of C corporations.
An inside tip our tax professional colleagues can offer is this: if you envision your LLC growing big and potentially going public in the future, consider electing to be taxed as a C corp early on. It’ll simplify your transition and might have significant long-term tax benefits.
Broadest Array of Tax Deductions
An LLC taxed as a C Corp provides access to a broader array of tax deductions. It’s a mechanism that provides more flexibility, allowing deductions for fringe benefits like retirement plans and health insurance.
For most small business owners, these could lead to significant reductions in corporate income tax. Plus, the personal liability offered by the LLC stays in order.
Easy Transfer of Stock
In comparison with other business structures, such as a sole proprietorship or LLCs taxed under alternative schemes, the C Corp allows an easy transfer of stock. This flexibility can be pivotal for businesses considering expansion or seeking outside investors.
Corporate shareholders can freely transfer their shares without impacting the company’s operational status.
From the Federal Reserve Banks’ Small Business Credit Survey, 58% of small businesses reported that their growth plans were affected by their access to capital.
This suggests that an easy transfer of stock could enable some small businesses to attract more investment, expanding their financial horizons.
Eligibility for Qualified Small Business Stock Status
Attaining this status means that when an LLC member sells their shares, up to a whopping £10 million or 10% of their original investment can be excluded from federal income tax purposes.
This is remarkably better than the capital gains tax imposed on an S corporation or other business entities.
Access to Valuable Healthcare Fringe Benefits
The realm of healthcare fringe benefits is an S corp liability pitfall, but a boon for C corporations. As reported by the IRS, C corporations can fully deduct the cost of healthcare for employees without adding it to the employees’ wages, this includes the owners as well.
Employers can also leverage pre-tax dollars for insurance premiums. In turn, this reduces your company’s taxable income and impacts your personal tax returns favorably.
Drawbacks of an LLC Taxed as a C Corp
While a C corp taxation structure for an LLC has its advantages, it also brings along certain drawbacks.
Double Taxation
The most significant drawback of electing to be taxed as a corporation is the potential for double taxation. Unlike a pass-through entity, like an S corporation, where business profits are taxed only at the individual level, corporations endure a more burdensome process.
First, the business income is taxed at the corporate level. Then, when dividends are distributed to the shareholders, they’re taxed again on their personal income tax returns. This can lead to a higher total tax liability.
In 2023, the top federal corporate income tax rate is 21%, plus taxes at the shareholder level, which could be alarming for some small businesses.
Accumulated Earnings Tax
An LLC taxed as a corporation may be subjected to this tax if the IRS deems that the earnings and profits retained by the company exceed the reasonable needs of the business.
This is an additional tax aimed to prevent corporations from avoiding shareholder taxes by accumulating earnings, thus could potentially increase your tax liability. From our in-depth research, the accumulated earnings tax stands at a flat rate of 20%.
Limited Pass-Through Benefits
Transitioning from a disregarded entity like a sole proprietorship or a single-member LLC to a C corp might limit the advantages of pass-through taxation. As a C corp, losses cannot be passed through to offset income on personal tax returns, unlike in an LLC or an S corporation.
Being unable to utilize these losses immediately can be daunting, especially for small businesses that may start with more expenses than revenue.
Complex Tax Compliance
Another drawback of an LLC taxed as a C Corp is the complex tax compliance it poses. This typically involves multiple layers of taxation at both state and federal levels, which can complicate the tax filing process.
This is the case when dealing with personal holding company tax and sales tax.
For context, many LLCs elect to be taxed as a C Corp not expecting a higher degree of tax compliance. Small business corporations often overlook the alternative minimum tax, a mandatory tax that applies to the C Corps.
This underscores the need to understand tax-related implications fully before opting for a C Corporation.
Loss Limitations
Associating with a C Corp also means that losses are confined to the corporation. This is a significant reversal from an LLC’s default tax classification, which allows members to write off operational losses on their personal tax return.
On this matter, we’ve noticed that loss limitations can be a deterrent for businesses with fluctuating profits. For example, in the case of startup companies that typically experience initial losses, benefitting from these losses personally could ease financial burdens.
Additional Reporting Requirements
With an LLC electing to be taxed as a C Corp, the tax classification change also brings about additional reporting requirements. Not only do C Corps require more in-depth record keeping, but they also need to adhere to more corporate formalities.
For example, C corporations are required to file a separate corporate tax return (Form 1120) in addition to the personal tax returns of the shareholders. They must also comply with regulations such as holding regular board meetings and maintaining corporate bylaws.
So, Should You Opt to Be Treated as a Corporation
Deciding to switch your LLC’s taxation status to a C Corporation is no light matter. It should be given careful thought, considering the benefits and complexities involved.
It might make the most sense for your business if you envision significant growth, want to attract a broader pool of shareholders (bearing no nationality restrictions), and are prepared to handle additional compliance and possible double income taxation.
In light of our expertise, we’ve observed that businesses with higher personal income taxes than corporate rates often find LLCs electing to be taxed as C corporations beneficial.
However, if you are only looking to pay self-employment taxes at a lower level, an S Corporation taxation may be more beneficial.
