Most advisors, particularly those not familiar with both the law and tax sides of the incorporation decision, tend to advise using an LLC over a C Corporation. And, it’s true, often an LLC is preferable for tax reasons. However, this is not always true and any businessperson should pay attention to the differences before making a final decision.
The Limited Liability Company, or “LLC,” is considered to have better tax treatment, because it avoids the “double taxation” problem of traditional C Corporations. For example, a C corporation with a profit of $1 million would pay about $340,000 in federal taxes on the profit, leaving $660,000 of profit. When distributed as dividends, this would get taxed again at 20% (sometimes 15%), for an additional $132,000 in tax, leaving an after-tax amount of $528,000. The same $1 million in an LLC would get taxed as direct income to the members, who are probably at the 40% (rounding up a tiny bit to make the math easy), so the after-tax profits are $600,000, a difference of $72,000 in favor of the LLC.
That’s the standard example explaining why the LLC is the better option. But not all businesses are alike. A C Corporation offers advantages, including tax advantages, in certain situations.
For example, most states charge a yearly “fee” on each LLC. This fee is not large, but it is mandatory and must be paid whether or not the LLC makes a profit. In California and some other states, it is also based on revenues, not profits. An LLC with high revenues, but not yet making much in profit would be charged thousands of dollars that are not charged to a C corporation. Also, assuming you are in the highest tax bracket, C corporations have low tax rates on lower levels of profit, often significantly lower than the 40% rate most LLC members would pay on same profit, regardless of double taxation.
Another benefit of the C corporation is that it pays the taxes itself. Let’s look at the $1 million profit scenario above. In a C corp, if the company needs to keep the profit in the company as a reserve or to expand or some other reason, it has the $660,000 in the bank, ready to go. The shareholders have no additional tax. Although, when the money does come out, there is more tax – that only happens when and if the shareholders actually receive any money. If this were an LLC, the members would have to pay the $400,000 in taxes, reported on their personal tax returns, regardless of how much money actually made it into their hands. In this situation, the C corporation has $60,000 more in the bank than the LLC after taxes.
Also, foreigners will see big benefits from using a United States C corporation over an LLC. Because the US has a worldwide tax policy, an LLC member who is attributed LLC earnings will have to file US taxes, including information on their worldwide income. Although, depending on the circumstances, the additional US tax, if any, will often be small, the reporting and additional work will have to be done. This is not true of a C corporation, even if it actually distributes dividends. This difference alone can make a C corporation more attractive, even if it results in higher taxes.