Internet Business Entity Choice
In terms of the typical e-commerce startup, new entrepreneurs usually want to know whether they should form a corporation or an LLC. Any other business structure, such as a limited partnership or limited liability partnership is not suitable for sole operators and not very practical for partners selling goods online. The same basic principles of choosing a business entity are really no different for conducting e-commerce. Ruling out other types of business entities for purposes of e-commerce, my prior post on corporations vs. LLC’s provides a detailed breakdown of the pros and cons of forming a C corporation, S corporation or LLC.
Largely, the right choice of business entity for conducting e-commerce will depend upon the ownership structure and federal and state income tax considerations, and not the fact goods are being sold online by itself.
C corporations Not Ideal
Generally speaking, most startups will have little reason to form a C corporation. C corporations are taxed at a flat rate at the entity level and that same stream of revenue is taxed again at the individual shareholder level. This is known as ‘double taxation’ in corporate tax parlance and should be avoided for almost all small, non-public startups. (Perhaps there could be seasonal sales and taxation considerations depending upon the type of goods being sold that may differentiate e-commerce businesses).
Small business owners that qualify can organize a corporation and elect to be taxed under subchapter S of the Internal Revenue Code. In making such an election, the owners (shareholders) elect to avoid double taxation at both the entity and individual shareholder level. There is no federal corporate income tax on S corporations. Some states impose taxes on income on S corporation profits (i.e. “replacement taxes”) and this can vary from state to state. Like LLCs, net profit or loss after expenses for S corporations, including salaries paid to employees and shareholder-employees, is “passed through” to shareholders’ personal tax returns (via Schedule K-1).
Are LLCs Taxed As S Corporations The Holy Grail?
Business organization attorneys often recommend forming an LLC and then elect S-corporation status to maximize tax benefits. Businesses with multiple owners can combine the flexibility of using an LLC with the tax advantages of an S-corporation. The certainties of electing S corporation status and paying only payroll taxes on wages the company earns can be a clear benefit. Of course, this is a blanket statement and there may be other reasons to form an S corporation outright instead, or some other business entity. If you are the sole owner in an S corporation tax structure, you will be a W2 employee as opposed to self-employed.
An LLC with partners is taxed as a partnership and the profits and losses are “passed through” to the members and there is no entity level income tax. The LLC avoids double taxation just like the S corporation. (Some states do impose replacement taxes on the income of LLC’s). If the LLC has only one owner, the IRS will automatically disregard the entity and treat the LLC as if it were a sole proprietorship (a “disregarded entity”). A single-member LLC does not file a tax return and the owner reports the income through schedule C on his or her individual return. An LLC is known as a “check the box” entity, which means it may elect corporation or partnership tax treatment.
If an LLC elects to be taxed as an S corporation, the owners (members) must comply with S corporation ownership rules. This means that only a single class of ownership (membership interest) can exist with no special distributions or liquidation rights falling to any member not in accordance with his or her membership percentage interest. There can also be no resident alien members, no more than 100 members and no corporations or partnerships can be members. Thus, electing S corporation status may not work for each startup entirely depending upon the ownership structure. Use of a single member LLC will be classified as a sole-proprietor for tax purposes and pay self-employment taxes on all income. If you make the S election, you will end up being a single member LLC that is taxed as an S-Corporation. This gives you the power of being the only owner without the tax penalty of being declared a sole proprietor.
New QBI Deduction Suggests Using LLCs?
However, things have certainly changed with the recent changes to Section 199A of the U.S. tax code in 2017. Now some business owners can receive a qualified business income (QBI) deduction allowing them to deduct up to 20 percent of their QBI. Solo and partner LLC members not electing S corporation tax treatment are taxed as a disregarded entity or as a partnership, respectively, by default. Each type of LLC owner receives the QBI deduction on up to 100% of their membership distributions outside of any salary paid to them by the LLC. LLC’s electing S corporation tax treatment can still receive the distribution on distributions falling outside of any paid wages. QBI is the net amount of income (or loss) from any U.S. trade or business (including in Puerto Rico), other than one conducted by a C corporation or as an employee. QBI does not include investment items such as capital gains or losses, dividends, or interest income that is not properly allocable to a trade or business. Thus, QBI is reduced by reasonable W-2 compensation to employees (including S corporation shareholder/employees) and by guaranteed payments to LLC partners. (In addition, any QBI must be reduced by the deductible portion of the self-employment tax, the self-employed health insurance deduction, the self-employed retirement contribution deduction, unreimbursed partnership expenses, charitable contributions related to the business, and interest expense incurred to purchase assets or an equity interest in the entity).
E-commerce operators with taxable income at or below the threshold amount (i.e., $321,400 for married filing jointly or $160,700 for single and head of household) have no limitations to the deduction (other than an overall taxable income limitation. The QBI deduction is subject to a W-2 wages/qualified property limitation that phases in over a $50,000 ($100,000) range for taxpayers with taxable income over the threshold amount. (Certain non e-commerce businesses that are specified service trades or businesses (SSTBs) are subject to another limitation (the SSTB limitation) that phases in over the same range starting at the same taxable income threshold). The math gets more complicated for non e-commerce businesses that are SSTBs).
The choice of entity, along with the taxpayer’s income, can affect the allowable QBI deduction. The existence of the QBI has certainly caused a re-thinking in the most optimal business structure for tax considerations alone. So, are there any general conclusions to draw with respect to LLCs vs. S corporations for e-commerce?
- Owners of e-commerce businesses that are LLCs generally have a higher QBI deduction throughout the phase-in range.
- Owners of e-commerce businesses with substantial owner compensation will generally have a larger QBI deduction if the business is an S corporation.
Given the recent tax code changes, a breakdown of all of these considerations by a qualified accountant is a necessity.
What About Non-Tax Considerations?
Other than taxation issues, the LLC has no ‘corporate formalities’ to follow than corporations. This basically means there will be less hassle and paper work involved with using an LLC (for instance there is no need for a board of directors, officers or the need to conduct annual meetings) as opposed to a corporation (and electing S corporation tax treatment). Typically, no required annual meetings notice, waivers of notice, resolutions and/or meeting minutes, etc. are required like with corporations.
Employment Insurance Contributions Without Employees
In addition, in most states and under federal law LLC member-owners not taking wages are not considered to be employees of the LLC. This means unemployment insurance contributions and and the added complexity of registration and quarterly and annual reporting filings with various state departments of employment/labor are not necessary. This saves LLCs with no non-owner employees from having to pay these costs.
Single owner website operators organizing an LLC not electing S corporation tax treatment presents a far more hassle-free approach.
LLC Member vs. Shareholder Creditor Rights
One important consideration for multi-owner e-commerce businesses is creditor rights. A creditor of an individual business owner is able to attach a judgement lien against the interest of a shareholder debtor and in essence step into his or her shoes with the same rights. This can be problematic for the other partners, especially when the debtor shareholder in question has a significant or a controlling interest. The result can be quite catastrophic including a potential forced liquidation of the corporation. With multiple owners, the notion of charging order protection becomes important. This is potentially a far more valuable asset protection strategy than organizing an actual corporation (C or S corporation).
Of course, if a single owner is looking to organize a business entity, it becomes a moot point-a creditor is not generally limited to seeking a charging order against a single member LLC debtor. Although, the state of Wyoming has recently enacted legislation codifying charging order protection for single member LLCs.
State Income Tax Considerations
Depending on the state of where the e-commerce business is being operated, there may be state income tax considerations in selecting a corporation or an LLC as the business structure. Most states (47) impose corporate income taxes for income derived in that state. Most states also impose income taxes on LLC profits, at least for multiple member LLCs. Businesses organized outside the state in which it conducts business will be subject to income tax only on income earned where it is doing business. For example, Illinois imposes a 1.5% personal property replacement income tax on all S corporation business income and multi-owner LLCs derived in the state. Most states impose a flat corporate tax rate on all business income earned in that state. A handful of states do not impose income taxes on corporations or LLCs, posing a factor to keep in mind when selecting a business entity type. California imposes an income tax on LLC gross income.
A franchise tax is a tax levied by a state for the privilege of either incorporating or qualifying to do business in that state. A franchise tax may be based upon income, assets, outstanding shares, or a combination. Some states base their corporate franchise taxes on the paid-in capital of a corporation. Other states may impose a flat franchise tax on corporations and LLCs. Some states impose a significant franchise tax while other states, such as Nevada have no franchise tax. All other things being equal, a review of the annual state income and franchise tax obligations in the state of organization between corporations and LLCs is warranted.
Simply organizing away from your home state to avoid corporate (or LLC) income taxes may not prevent your business from having to pay them at some point. This may hold especially true for Internet based businesses. In fact, the nature of e-commerce raises the question altogether of whether selling online imposes foreign state income tax obligations?
The nature of e-commerce and the sale of goods does not necessarily dictate that a certain entity should be used over any other business structure. Rather, choosing the “right” entity should be carefully determined based largely on federal and state income tax considerations, ownership structure, owner creditor rights and any additional work due to corporate formalities and other corporation filings.