This time of year is a good time to talk about one of the basic differences between a corporation and an LLC – pass through taxation. Pass through taxation means that the IRS ignores a business entity when collecting taxes and instead takes full payment from the owners on all the business’s income. Pass through taxes can give owners a big surprise on their 1040s at the end of the year, but is still often preferable to the double taxes paid by corporations.
Traditional “C” corporations are double taxed. First, the corporation pays income taxes on all the money that it makes. Then, after the corporation has already paid money on its own income, the owners are taxed on all of the dividends that they take from the corporation. All of that dividend money is taxed twice, once through the corporation and once through the owners.
To take an example: Say Carly’s Corporation is a C corporation that made $1,000,000 in net income in 2009, and Carly paid herself $100,000 in dividends. That $100,000 is part of the million that the Corporation claims. So both Carly’s Corporation and Carly are going to pay income taxes to the IRS on that money. The good news for Carly though is that she only pays taxes personally on that $100,000 dividend, not on the full million.
Now say Lenny’s LLC is a traditional limited liability company with $1,000,000 in net income in 2009, and Lenny paid himself $100,000 in membership distributions. The LLC would pay no income taxes, but Lenny would pay taxes on the full million in income. So there would be no double tax on the $100,000, but there would be a “pass through” tax on Lenny. To cover that bigger bill, Lenny might need to reserve a bigger distribution for himself.
What does this mean to you? First of all, now is a perfect time to look at 2009 and decide if your tax method worked. If you want to find a way to reduce your over-all tax bill, then pass through taxation might be preferable. If you have trouble getting large distributions from your company into the hands of the owners, then maybe you need to bite the bullet and deal with double taxes. Even though you have probably already formed a corporation or LLC, you can usually elect to be taxed as an “S” corporation or to have your LLC double taxed – allowing either tax treatment for either entity.
Second, if you are starting a business. The decision about how taxes are calculated might be the deciding factor between starting an LLC or a Corporation. There are two people who can help you make the tax planning decision; one is your accountant and the other is your attorney.
One other note; none of the above takes into account the tax bracket of the owners or the corporations; and none of the above takes into account the other important differences between corporations and LLCs. Always crunch the numbers before you make a big move and don’t let tax planning be the only thing that guides your business decisions. You only have to pay taxes on money after you earn it.
