You’ve decided to start a business of your own. Or maybe you have been running one as a sole proprietor and have decided you need to protect your personal assets from those involved with your growing business. You might even decide that there could be a tax break in it for you. Whatever your reasoning, you’re likely contemplating a choice that many entrepreneurs face: Should your enterprise be structured as a limited liability corporation (LLC) or an S corporation (S corp).
These two organizational forms have similarities and differences–which can make choosing between them and others, like a C corporation (which includes publicly-held companies), confusing at best. Each state might also have different rules that come into play. That’s why you’ll want to get some input from an Exemplar accountant and/or attorney to help you decide what might be the best fit for your business.
About Limited Liability Corporations
LLC stands for limited liability company, and it can protect the personal assets of a business owner from lawsuits
An LLC IS Best for Your Business When:
Many LLCs will benefit most from the default LLC tax classification. LLC owners often put any profit back into their small businesses each year to promote growth. And without profit and distributions, there’s no basis for electing an S corp.
The default LLC tax structure is best suited for businesses with these characteristics:
- Their owners reinvest profit back into the business to promote growth
- The cost of bookkeeping and payroll services would outweigh the tax benefit of an S corp
Advantages of an LLC:
- The owner of a single member LLC doesn’t have to file a tax return for the LLC, as they only report the activity on their personal tax return.
- Ease of setup: Most LLC forms are only a single page for single member LLCs.
- Inexpensive to start: The cost of setting up an LLC is also inexpensive, usually just a couple hundred dollars.
- Guidelines: The red tape involved in forming an LLC isn’t as stringent as that involved with S corps, which also leads to savings on accountant and attorney fees, among others.
Disadvantages of an LLC:
- Self-employment tax: Single member LLC owners are required to pay self-employment tax on income generated in the LLC, which means making quarterly estimated payments to the IRS.
- Owners of LLCs must make sure they don’t pierce the “corporate veil,” meaning they have to operate the LLC separately from their personal affairs. There have been cases where a business owner lost their protection because there was no distinct difference between the LLC and its owner. For more information, please contact us.
According to the IRS, S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
An S-Corp Is Best for Your Business When:
It only makes sense to file taxes as an S corp if there is enough profit carried over from year to year to pay owners a reasonable salary and substantial distributions.
Under an S corp, business owner(s) can save about 17 percent on the distribution portion of their income if the following statements are true:
- The business can pay the owner(s) a “reasonable salary”.
- There are substantial distributions year over year.
- There is a positive return on investment for payroll service costs.
- The business meets S Corp requirements (see below).
Requirements for an S-Corp:
S corps must meet four requirements:
- They can have no more than 100 shareholders.
- All shareholders must be private individuals (not other business entities).
- Shareholders cannot be nonresident aliens.
- The business may only issue one class of stock.
Advantages of S-Corp:
- The main advantage of an S corp is that it offers tax benefits when it comes to excess profits, known as distributions.
- The S corp pays its employees a “reasonable” salary, which means it should be tied to industry norms, while also deducting payroll expenses like federal taxes and FICA.
- Then, any remaining profits from the company can be distributed to the owners as dividends, which are taxed at a lower rate than income.
Disadvantages of S Corp
- S corps have more strict guidelines than LLCs. Per the tax code, you must meet the following standards to create an S corp:
- Must be a U.S. citizen or resident.
- Cannot have more than 100 shareholders (a spouse is considered a separate shareholder for the purpose of this rule).
- Corporation can only have one class of stock.
- Profits and losses must be distributed to the shareholders in proportion to the shareholder’s interest. For example, you can’t have disproportionate distributions of dividends or losses. If a shareholder owns 10 percent of the S corp, he or she must receive 10 percent of the profits or losses.
- It is more expensive to form an S corp.
- Shareholders must adhere to the requirements at all times. If they don’t, they risk disallowing the S corp election, and the corporation would be treated as a C corp with its corresponding restrictions.
- Passive income limitation: You can’t have more than 25 percent of gross receipts from passive activities, such as real estate investment.
- There can be additional state taxes for S corps.
- Shareholders should pay attention to paying themselves a “reasonable” salary for the work they perform for the S corp, since the IRS is increasingly scrutinizing S corps for this.
S Corp or LLC?
Tax treatment is important to consider when forming a business. However, if you’ve already formed your business entity but are unhappy with the tax consequences headed your way, don’t stress. You can elect, for example, to have your LLC be classified as an S corp. This may help legitimately avoid self-employment taxes.
Many entrepreneurs set up their new ventures as LLCs to have some legal protection for their personal assets. When your business grows, though, it’s a good idea to speak with your CPA and look into filing as an S-corp for the financial benefits. You should also determine how many investors, stock classes and foreign owners will be members of your LLC in order to follow the proper guidelines under your state laws.
Exemplar Attorney’s and CPA’s Can Answer Your Tax & Legal Questions.
Of all the choices you make when starting a business, one of the most important is the type of legal structure you select for your company. Not only will this decision have an impact on how much you pay in taxes, it will affect the amount of paperwork your business is required to do, the personal liability you face and your ability to raise money.
There is no simple answer to which tax classification you should pick, but an Exemplar accountant or business attorney will be able to help you choose between an S corp versus LLC. If you’d like to talk through your entity formation needs, please contact us, today!
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