When forming a new business, your choice of business entity is critically important as it will determine how the business and owners are taxed, how the business is managed, and the liability protection afforded to the owners.
Entrepreneurs frequently ask me whether they should form an Oregon limited liability company (“LLC”) or an S-corporation. This is an important question, and the answer is somewhat confusing. In brief, you do not need to decide between the two: you can form an LLC under Oregon law and elect to have the LLC taxed as an S-corporation. In this article, I attempt to unpack my answer above and help the reader understand how Oregon business laws and federal and state income tax laws work together.
At the outset, the entrepreneur must determine what type of business entity to form under state law. Under Oregon law, an individual or group of people can form an LLC or a corporation by filing articles of organization or articles of incorporation, respectively, with the Oregon Corporation Division. While there are other types of entities, I will only discuss LLCs and corporations here as they are the most common.
By default, under the Internal Revenue Code (the “Code”) and Oregon tax law, a single member LLC will be taxed as a sole proprietorship, a multi-member LLC will be taxed as a partnership, and a corporation will be taxed under subchapter C of the Code, and is referred to as a C-corp.
The sole proprietorship is “disregarded” for tax purposes meaning that the LLC will not need to file its own tax return; rather, all business related activity will be reported on Schedule C of the proprietor’s personal income tax return. A partnership will need to file its own tax return and the income tax obligations relating to the LLC will be borne by its members as they agree (with some limitations). The LLC itself will not have any income tax liability. The C-corp will need to file its own tax return and will be obligated to pay income tax. Additionally, the corporation’s shareholders will pay income tax on any profit distributions taken by the shareholders. Thus, the income of a C-corp is taxed twice.
The LLC (whether single or multi-member) and the corporation can elect to be taxed under subchapter S of the Code. A business (LLC or corporation) that has made this is election is referred to as an S-corp. If the S-election is made, the business (whether an LLC or corporation) will need to file a tax return, but the income tax obligations relating to the business will be borne by its owners in accordance with their ownership percentage (e.g. the owner of 50% of the outstanding shares or membership interest will bear 50% of the income tax obligations of the business).
Advantages of Making an S-ElectionFor a C-corp that has made an S-election, the corporation itself will not pay any income tax; rather, the income tax obligations will flow through to the shareholders (thus, shareholders avoid the double tax paid by a C-corp).
For single member LLCs (taxed as sole proprietorships) and multi-member LLCs (taxed as partnerships), an important advantage gained from making an S-election relates to the amount of self-employment tax paid. By default, sole proprietors and partners are considered self-employed and will be required to pay Social Security tax (12.4%) on the first $113,700 distributed by the LLC and Medicare tax (2.9%) on all money distributed by the LLC.
However, if the LLC member(s) elect to be taxed as an S-corp, the member(s) can take a reasonable salary as employees of the business, and all money distributed to the member(s) above the reasonable salary will NOT be subject to the Social Security and Medicare taxes. This can result in significant tax savings for the business owners who actively work in the business.
Disadvantages of Making an S-ElectionS-corps are subject to certain limitations that do not apply to partnerships and C-corps.
In brief, an S-corp cannot have more than 100 shareholders; all shareholders must be U.S. citizens; and, with a few exceptions, all shareholders must be human (as opposed to business entities or trusts). Further, unlike partnerships, the owners are not free to agree upon how profits and losses will be allocated, or how profit distributions will be made. Rather, S-corp owners must share the economic attributes of the business according to their ownership percentages. An S-corp may only have one class of stock or membership interest.
If both LLCs and private corporations can make an S-election, which entity is most appropriate in your case? This analysis requires consideration of many factors including the desired liability protection for the owners, how the business will be managed, and the future plans of the owners. As a rule of thumb, an LLC taxed as a sole proprietorship or partnership should be given first consideration. I encourage the reader to seek the advice of a business lawyer and accountant to determine which type of business entity is most appropriate for your next venture.
Peter A. Christoff
Merrill O’Sullivan, LLP
805 SW Industrial Way, Suite 5
Bend, Oregon 97702
Office: 541-389-1770
Facsimile: 541-389-1777
www.merrill-osullivan.com
