Whether you're launching a new manufacturing company or you
already own one, how that entity is structured can have a significant impact on
taxes. So, choosing the right structure is important. And switching to a
different structure may be a smart business decision as the company grows or
its goals change.
3 business structures
Income taxation and owner liability are the main factors that
differentiate one business structure from another. Many owners choose an entity
that combines pass-through taxation with limited liability, namely a limited
liability company (LLC) or S corporation. C corporation status should
generally be reserved for manufacturers with aspirations to expand operations
widely and raise capital.
Let's take a closer look at the big three:
1. LLCs. Of
the three structures, LLCs are the easiest to create and maintain. Plus, you
can generally switch to a corporation down the road without dire tax
consequences — whereas switching in the opposite direction may trigger a
substantial tax bill.
LLCs are formed under state law and provide personal asset
protection for owners (called "members"). Any liabilities or losses are covered
by the business's assets. They also don't require a board of directors or limit
the number or type of members.
The IRS classifies a domestic LLC with at least two members as a
partnership unless the LLC elects to be treated as an S corporation or
C corporation. (See below.) Partnerships are pass-through entities, so
income, losses, deductions and credits pass through to the owners for federal
tax purposes, and income is taxed at ordinary income tax rates of up to 37%.
Income that for federal tax reporting purposes passes through to owners who
also work in the business is subject to self-employment tax, whether or not the
income is actually distributed to the owners.
A single-member LLC that doesn't make a corporate election is
treated as a "disregarded entity" — basically, a sole proprietorship — for
federal income tax purposes. (For employment tax purposes, it's treated as an
entity separate from the member.)
2. S corporations.
Manufacturers organized as S corporations are also pass-through entities, but
S corporations are more complicated than LLCs. For example,
S corporations must operate domestically and can have no more than 100
shareholders and only one class of stock.
S corporation profits and losses must be allocated based on
ownership shares, while LLCs generally can allocate profits and losses on any
basis, provided it's set forth in the operating agreement. For example, the
agreement can allocate greater profits to an LLC member who invested more money
in the business upfront.
On the plus side, S corporations can offer a significant
advantage over LLCs when it comes to self-employment taxes. Specifically,
though employee-owners must be paid a reasonable salary (neither too low nor
too high) that is subject to the 15.3% self-employment tax, distributions of
profits generally aren't subject to the tax. (Note that S corporation
owners are taxed on profits regardless of whether the profits are distributed.)
That can amount to substantial tax savings for these owner-employees.
3. C corporations.
Manufacturers structured as C corporations are recognized as separate
taxable entities for federal income tax purposes and are subject to a 21% tax
rate. A C corporation's profits are taxed to the corporation when earned —
and then again to its shareholders when distributed as dividends, at a rate up
to 20%.
It's this dreaded "double taxation" that prompts many small
companies to conduct business as an LLC or S corporation. Moreover,
C corporations must satisfy numerous corporate formalities.
Other factors
If your manufacturing company is still relatively small and
doesn't have or desire outside investors, it makes sense to remain an LLC.
Among other reasons, losses can offset other income on your individual tax
return (subject to income-based limits). Also, the now-permanent Section 199A
qualified business income (QBI) deduction generally allows you to deduct 20% of
your QBI on your personal income tax return (also subject to income-based
limits, though these limits are different from the loss limits).
Owners who receive a salary from an S corporation will
qualify for a smaller QBI deduction because the salary is an expense that
reduces the company's QBI. On the other hand, the self-employment tax savings
when the business is generating solid profits can more than make up for that.
And those savings could be reinvested in the company and used, for example, to
purchase new equipment that might qualify for 100% bonus depreciation (also
permanent now) or the Section 179 expensing election.
Making the right choice
Determining the right form of ownership for your new
manufacturing company or deciding whether to change the structure of your
existing company isn't easy. There are many pros and cons to weigh before
coming to a decision. We can provide the tax advice you need to help you make
the right choice.
