Sometimes a small concept can make a huge difference. Because of the difference between Limited Liability Companies (LLCs) and Corporations, the money you put in to start them is treated in very different ways.
Overview of Corporations
A corporation is a distinct legal entity from the owners. It was created to separate management from ownership in order to lessen the legal liability of the owners. Owners hold onto a portion of the company in devices called shares. Shares do not need to by physical pieces of paper and are defined at the state level, usually by statute.
Ownership of a share or more than one share entitles a person to certain rights in the company, depending on the bylaws, stock purchase agreement or other contracts associated with the purchase or acquiring of the shares. Most shares come with the right to vote for the Board of Directors and on larger decisions, like whether or not to sell the company to a competitor or dissolve the company.
The Board of Directors in a corporation appoints the management of the company. The most iconic example of the management is the Chief Executive Officer, or CEO for short. The management then runs the day to day operations of the company.
Overview of Limited Liability Companies
A limited liability company, or LLC for short, is a collection of owners (usually called members) acting together towards a common business purpose. The LLC is not distinct from the owners, but the LLC creates a limitation on personal liability just like the corporation does. LLCs were also created by statute and the rules for their operation are created under state law.
Under North Carolina law, since 2014, members are by default managers of the company. This can be changed in the LLC’s operating agreement to have a single manager, group of managers, board of managers or any other setup that (1) has at least one manager, and (2) does not infringe on the guaranteed rights of the other members.
Tax Treatments
Disregarded – If a company is disregarded for tax purposes, it means there is only one owner, the company is not a corporation, and the company has not made some alternative tax election. This can only occur in sole proprietorships and single member LLCs. Companies taxed as disregarded entities report all income on the individual’s 1040.
Partnership – If a company is tax as a partnership, it means that there are two or more owners, the company is not a corporation and the company has not elected to be taxed as a C or S corp. This can only occur in partnerships and multiple member LLCs. Companies taxed as partnership must send in a partnership tax return, issue K-1s to their owners and report the K-1 income on the owners’ tax returns.
C Corporation – If a company is taxed as a C Corporation, it means that the company is either a corporation or an LLC. This is the default tax treatment of a corporation and able to be elected as an LLC. C Corporation taxation is the only type of taxation that has a separate tax rate for all business profit; however, salary to owners is considered a business expense, resulting in only income tax for all salaries paid to owners.
S Corporation – If a company is taxed as an S Corporation, it means that the company is either a corporation or an LLC and has elected to be taxed as an S Corporation. S Corporation election allows owners of a company to pay themselves a reasonable salary under partnership taxation rules and then pay themselves the remaining profit as distributions on equity, thereby saving the FICA taxes they would normally have to pay on ordinary income.
Startup Funds
Corporation – When you put money into a corporation, you are investing in exchange for shares. Generally, you only contribute money in exchange for new shares, but although not advisable, you can structure this different. Because you’re exchanging money for shares, you can only recoup the money you’ve contributed when you dispose of the shares, either selling them to a third party or to the company. Any income you receive otherwise would be ordinary income or dividends in a corporation.
For example, if you contribute $100,000 for 100,000 shares, each share is worth $1. If you get paid $50,000 the first year, but retain all of your shares, you pay income tax on the $50,000. On the other hand, if you sell back 50,000 shares in exchange for $50,000, you will pay no taxes, as it will likely all be considered return on capital. If you sell back 10,000 shares in exchange for $50,000, a portion of the $40,000 gain would likely be considered capital gains instead of income for tax purposes and $10,000 would likely be considered return on capital. Be careful with this, however, because your company’s valuation will affect these things. You cannot completely avoid income tax by trading your stock back, but if your company’s value has increased significantly since you received your shares, it may be reasonable for the income to be capital gains opposed to income tax. Talk to a CPA or tax attorney before trying this later strategy.
Limited Liability Company – When you put money into an LLC, you are investing in exchange for equity. Under LLC taxation, this increases your capital account. When the LLC profits, you increase your capital account as well. You’re subject to tax on only the amount you’re liable for when the LLC profits, not when you’re paid. This means that you will not be subject to certain taxes when getting paid because you’re being paid above and beyond the profits.
For example, if you invest $100,000 in your LLC and you’re the sole owner (100%), and your LLC makes $50,000 the first year. If you pay yourself $50,000, you pay income tax on the entire $50,000. If you pay yourself $60,000, you’re only subject to income tax on the first $50,000 and the $10,000 would be return on capital.
Conclusion
LLCs can give you your return on capital faster as the company grows and is able to support itself whereas you must sell your shares of the corporation in order to take advantage of the return on capital tax treatment of corporate stock. These two different ways of handling taxation and investment may make the difference between forming a corporation or forming a limited liability company. There are many other factors, however, that you should be aware of.
If you have any questions regarding the tax treatment of a type of entity or which type of entity you should form, feel free to contact us at richard@lawplusplus.com or by calling 919-912-9640.