Corporations vs. LLCs

If you conclude that it is best for your small business to form as an entity which offers limited liability to the business owners, though doing so may involve a bit more paperwork and expense, you have two primary choices: a corporation or limited liability company (an LLC). Figuring out which option is better will be different for each business, but there are some general concepts regarding the differences between corporations and LLCs which may be of some help to anyone considering forming a business. Of course speaking to an experienced business law attorney can be helpful in determining the proper business entity for your specific situation.  For more information about formation of each particular type of business entity, see our articles regarding forming a LLC in New Mexico, and forming a corporation in New Mexico.

When is an LLC best?

For most small business, the fact that LLCs are generally flexible and on the simpler side renders a LLC a wiser choice, as opposed to a corporation. New Mexico LLCs are particularly simple because of the relaxed reporting requirements for LLCs in New Mexico. If a small business will hold or own property such as real estate whose value is likely to increase, then using an LLC is also a wise choice. This is so because the standard for corporations (often referred to as “C corporations”) is that both the business and its shareholders will be subject to taxation in the form of a “double tax,” meaning the shareholders are taxed as well as the corporation itself on any increased value of the corporation’s property, if the property is sold. LLCs differ in that the business’s owners are taxed while the business is not, thus avoiding the double tax structure which comes along with a corporation. Thus, for entrepreneurs looking to pay tax only once, an LLC may be the best bet.

When is a corporation best?

Despite an LLC’s ability to avoid double-taxation, an LLC is by no means right for everyone. In some situations, there will be other considerations that may trump the importance of a single tax, and weigh in favor of choosing a corporation over an LLC. Some of those considerations may be:

• If you anticipate that your business will have several investors, or you anticipate raising money from the public. Even though an LLC may be effective when a business has a small number of investors, things may become complicated if the number of investors were to increase. You may experience resistance from would-be investors if you are unable to offer them corporate stock certificates as proof of their investment in your business. So, instead of trying to persuade them to invest regardless, it is wiser to incorporate rather than form an LLC if attractiveness to investors is a primary concern.
• If you plan on offering extensive fringe benefits to the owners of your business, a corporation may be better suited to your situation than an LLC. In many situations, forming a corporation leaves the incorporator with expectations that he or she will be both an owner and an employee of the company. For example, the corporation could select you as its CEO and pay you a salary which is tax-deductible, and offer fringe benefits too, which may include paying your health insurance premiums or reimbursing you for the cost of any medical expenses. These costs can be deducted by the corporation, as they are not regarded as taxable employee income. This differs from an LLC in that LLCs are only able to deduct a portion of insurance premium payments. Also, some fringe benefits offered the LLC members are not treated favorably with regard to taxation.
• Finally, if you want to attract and keep employees by offering them stock options or incentives, a corporation may be better for you. In general, an LLC does not have stock, but a corporation does. Though an employee of an LLC can be offered ownership interest in the company, this is not always an efficient process and is likely to be far less attractive to most employees than the kind of stock options offered by a corporation would be. So, if you plan to offer your employees ownership interest in your business, a corporation may be a better fit.

When is an “S Corporation” best?

Because business owners who are actively involved in their business in that they are “employed” by the business are made to pay self-employment taxes on the income they take, S Corporations may seem an attractive option. Generally, self-employment taxes are those taxes collected by the IRS from someone who is self-employed. Presently, the IRS will collect 15.3% of a self-employed person’s first $117,000 earned in a year, and then collects 2.9% on any amount earned above that.

With regard to S corporations, self-employment tax works differently. For those who hold shares in an S corporation, self-employment tax is levied on any income gained as compensation for services rendered but is not levied on profits which the person receives as a shareholder (which is passed through to the person automatically by the corporation). Conversely, self-employment tax can be levied against an LLC owner’s full share of the profits of the LLC. The rules are different for LLC members, and are not as clear. LLC owners can reduce the amount of self employment taxes they pay by paying themselves through payroll  (and having taxes withheld) as opposed to taking distributions.

The IRS has proposed certain regulations, which Congress has not yet adopted or rejected, which would effectively levy self-employment tax against the entire share of LLC profits received by an LLC owner in several specific situations. Thus, a shareholder of an S corporation may be able to pay less self-employment tax than a member of an LLC would pay on the same amount of income in a given year. If this is a major concern for you, you’ll need to determine if a potential tax savings is worthwhile enough to outweigh the advantages of an LLC, such as a flexible management structure and more relaxed record keeping. As yet another option a business can be formed as a limited liability company and can then elect s-corporation taxation. For more information about business formation in New Mexico, be sure to contact one of our expert attorneys.