When I meet with someone starting a business, I start by learning about what the business owner wants from the business. Once I have an idea of what they want to accomplish, I can ask my follow up questions. The first question I usually ask is what structure they would like for their new business. Most of the time I get the response, “I think we should go with an LLC.” When I ask them why, most people don’t have an answer. In my experience, clients have heard that the LLC was created to help small businesses and a corporation is for large companies. They know that they are starting a small business. Why would we recommend anything else?
Unfortunately, choosing a corporate structure is slightly more complicated than having a “go to” structure. After listening to what a client would like for their business, I can point them in the best direction depending on their goals for the business. I’ve outlined some of the most common types of business structures and give my insights on when to use each structure.
LLC Instead Of a Corporation
I think it is best to start with describing what an LLC means and what options this structure has. The main benefit to filing an LLC is a section of the state law that specifically states “A debt, obligation, or other liability of a limited liability company is solely the debt, obligation, or other liability of the company.” Or even simpler, if the company defaults on a debt or has a judgement against it, the members and managers have a significant level of protection. This is the law that new business owners get warm and fuzzy from when they think about an LLC. What they don’t understand is that this protection isn’t all that different from the “corporate veil” provided by a corporation in the state of Florida. If we were to look at business structures on a scale, sole proprietors and partnerships have less liability protection than an LLC. Corporations have about the same protection as an LLC.
Something that many people do not understand, and reading articles on the internet does not help with, is that the LLC is a little different in the state of Florida. Most articles refer to an LLC as having pass-through taxes and leave it at that (i.e. incorporate.com’s llc article). While this can be true, it may also be false. The reason is because the LLC has sub-types. A quirk of the LLC in the state of Florida is that it can be treated similar to a C Corp, S Corp, Partnership, or a Sole-Proprietorship. When an LLC is setup, the owner is required to select one of these sub-types so the state and federal government understand how to treat the LLC. If a type is not chosen by the owner, most companies that perform this service default the LLC to the disregarded entity which is similar to electing to be treated as a Sole-Proprietorship. I will explain why this could be bad later.
Another misconception I would like to point out is that folks believe that an LLC is cheaper to operate. At the time of this writing, the state filing fees for an LLC start at $125 and the filing fees for a corporation start at $70. It also costs $138.74 annually for an LLC and $ 150 annually for a profit corporation to file the state required annual report. It’s my opinion that these fees are nominally different, and unless you are planning on taking your corporation public, the maintenance for them is about the same.
So should you choose an LLC in Florida? The costs and the main benefit are approximately the same as a corporation. But, I still believe that many businesses shouldn’t. There are cases where it is truly beneficial to setting up an LLC as a partnership or disregarded entity, but most small businesses do not fit those cases. One small benefit to point out here is that a disregarded entity LLC may save some money on income tax preparation and filing because they only have to file one return instead of two. In my opinion, this is small cost difference should not weigh heavily when there are better savings elsewhere.
The biggest downside that we see with business owners that form an LLC is when they are classified as a “disregarded entity”. What this really means is an LLC that is treated like a sole proprietorship. Now don’t get me wrong, it’s great that they formed an LLC and got liability protection, but they have given up control over how they are taxed. The income made by the LLC may be subject to “employee” and “employer” share of FICA taxes, which can sharply increase the tax liability on the income tax return.
Most clients that we see can benefit most from an S Corporation structure. The shareholders have liability protection afforded by the “corporate veil”, the income is not taxed twice, and the shareholder(s) can have control over how much FICA tax they pay. I wish most of my clients would have chosen this structure.
When they do, I can usually help them save more money on their taxes.
Earlier I spoke about the “corporate veil”, but a down side to the “corporate veil” can be corporate income taxes also known as “double taxation”. This is a problem that plagues the C Corporation, but most people don’t realize that the federal government does not tax S Corps on the corporate level and the state of Florida has exempt them as well. So when does the income get taxed? It is taxed on the individual shareholder level at their income tax rates. This is similar to what most people expect from the tax structure of an LLC.
As for payroll taxes, an S Corporation can help a shareholder regulate how much they pay. Let’s look at an example for this. Let’s say we have two business owners. One owns an LLC set up as a disregarded entity and the other is the only shareholder in an S Corp. At the end of the year both companies realize a profit of $100,000. Because the LLC is treated like a Sole-Proprietorship, the owner must pay “Self-Employment Tax” on the income the business made. (Self-Employment Tax is equivalent to the employee and employer share of FICA taxes.) The LLC owner will have to pay an extra $14,130 in taxes.
Meanwhile, our S Corp owner is faced with a different situation. As an officer of the corporation, the shareholder generally is considered an employee of the corporation and must receive a paycheck. The S Corp owner decides to receive a paycheck that totals $50,000 per year. Because of the way the tax laws work, the S Corp owner only has to pay payroll tax on this amount, approximately $7,065. In a very over simplified summation, this owner has saved a little over $7000 just because of corporate structure.
The final question becomes “What about C Corps?” I’ve hinted at some of the benefits and troubles earlier, but there can be a good reason to set up shop as a C Corporation.
We know double taxation is a problem that the C Corp faces, but what does that mean. Simply put, it means the income the Corporation generates gets taxed and when the shareholders receive this income as dividends, they too must pay income tax on the amount they receive. And the tax can be substantial. The federal corporate tax rate varies from 15% to 35% and the state rate 5.5% (after some deductions). Then take out the shareholder’s tax and the government has taken a large portion of the income created. So why the C Corp?
The C Corp, like most of the structures we discussed here, has liability protection. The C Corporation does have benefits though. One benefit is no limit on the number of shareholders. One of the drawbacks that an S Corp faces is a limit of 100 shareholders. This is why an S Corporation is not the method that most people use to take a business public. When clients tell me the purpose of their business is to have its shares on a stock exchange or have a large number of private investors, I point them towards a C Corp. It is designed for that purpose. The other reason we point clients to the C Corp is simply because they have limited choices. Foreign non-resident business people who want to have a corporation in the United States cannot file for the S election. This leaves them with the C Corporation.
For most small businesses, these are not benefits that they are seeking. And most businesses that are starting out can start with a structure that fits their needs today and then create a C Corp and migrate the old business into the new one.