As a business owner, you are bound to be decisive and do what it takes to make the right choices for your business. One question you have to ask yourself is, "Which business structure is right for my business?"
There are two options, which you probably already heard: Limited Liability Company or LLC, an S-Corporation or S-Corp. Both business structures have their own differences in various aspects, so it is important to understand these distinctions to be able to choose what is right for your business.
If you are still struggling to think about it, this article will provide you with information that will help you decide. Let's dig deeper!
What is an LLC?
An LLC, or limited liability company, is a legal type of business structure that has the advantages and protection of a corporation and a partnership or sole proprietorship.
It is a common choice among small businesses, especially startups, due to its advantages in terms of flexibility and liability protection.
This signifies that the business is recognized as a separate legal entity, where the owners are called members and are not personally liable for the debts and obligations of the business.
Additionally, LLCs can be taxed as a corporation or as a passthrough entity, where the profits and losses are passed on to each member's personal tax returns.
What is an S-Corp?
An S-Corporation, also known as an S-Corp, is a legal type of business structure in the United States that provides specific tax advantages while maintaining the limited liability protection of a corporation.
It is named after Subchapter S of the Internal Revenue Code, which outlines the rules for this type of corporation.
Although, your business must follow certain conditions to qualify for S-corporation status such as:
Be a domestic corporation or LLC
Have only allowable shareholders
Maybe individuals, certain trusts, estates and
May not be partnerships, corporations, or non-resident alien shareholders
Have no more than 100 shareholders
Have only one class of stock
Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations).
If you want to know how the process of filing is done, you should consult a tax professional or simply visit the IRS website for verification if you already have an idea of how it's done.
Benefits And Drawbacks Of LLC And S Corp
Whether you're a start-up business or have been in business for several years, one way to help you decide if you can form an LLC or elect an S-Corporation is by checking the different benefits and drawbacks of both business structures.
In fact, this could also help you decide if you are thinking about switching to an S-corporation.
Choosing any of the two types of entities may come with advantages and disadvantages, which is why it is your choice which risk you want to take.
As a business owner, there’s no real guarantee of anything, but with proper strategy and organization, there will always be a way to succeed.
Now that you are aware of the key differences between these business entities, let's examine the following differences to understand which could be the benefit or drawback when choosing between an LLC and an S-Corp:
Limited Liability Company
Benefits of an LLC
Limited liability protection:
Shields personal assets from business liabilities.
Pass-through taxation: Profits and losses flow through to owners' personal tax returns.
Flexibility in management and ownership: Customizable structure to suit business needs.
Easy startup and upkeep:
The process is simple to get done and fees are not expensive.
Benefits of an S-Corp
Pass-through taxation with tax savings: Income passes through to shareholders, avoiding corporate-level taxes.
Limited liability protection: Personal assets of shareholders are generally protected.
Perceived credibility and professionalism: S-Corporation status may enhance business reputation.
Not subject to self-employment taxes: Self-employment tax and FICA payroll taxes are not levied on the remaining profits of your S Corp. There is only income tax due on those profits.
Shareholders can be considered employees of their own company: If shareholders work on behalf of the company, they are regarded as employees as well and are entitled to compensation.
Drawbacks of an LLC
Administrative and compliance requirements: Some record-keeping and reporting obligations.
Subject to self-employment taxes:
6.2% social security and 1.4% Medicare taxes
Owners cannot be employees of an LLC: LLC members cannot receive compensation in the form of wages and salaries. LLC owners are considered members, or owners, under state law.
Drawbacks of an S-Corp
Additional compliance responsibilities: Meeting certain corporate formalities and record-keeping.
Ownership limitations and restrictions: Eligibility requirements on shareholders and a number of owners.
Not a preferred entity type for investors: The reason behind this is that S corporations only provide one kind of stock, making it more difficult to keep a controlling interest.
Can only have one class of stock: There can only be one class of stock in an S corporation. A corporation is regarded as having one class of stock for these purposes if all of its outstanding shares of stock grant the same rights to distribution and liquidation proceeds.
As you can see in this example that there are two clear tax savings in an S-Corp vs an LLC.
The first is the savings in the social security and Medicare taxes. An LLC’s flow-through income is subject to self-employment taxes, which are composed of social security and Medicare taxes. Self-employment taxes are taxed at 15.3% of 92.35% of the net income.
With an S-Corp election, the net income is not subject to self-employment taxes. The shareholder would likely pay a reasonable salary or wage of some sort where some social security and Medicare taxes are paid by both the employee and the employer. The employer matching taxes are an added business deduction.
There’s also the savings in income taxes. Due to the fact that the S-Corp paid owner’s wages and matched employer taxes that reduced the expenses and flow through net income, there is now less taxable income that the shareholders need to include on their personal returns.
Can An LLC Elect Be Treated As An S-Corporation?
An LLC can elect to be treated as an S-corporation for federal tax purposes.
This means that the LLC can choose to be taxed as an S-corporation while maintaining its limited liability company structure. However, it's important to note that the S-Corporation election is made specifically for tax purposes and does not change the legal structure or limited liability protection of the LLC.
For instance, when a partner in a partnership is required to pay self-employment tax on his or her distributive share of the business income, electing an S-Corporation may be wise because the owner won't be charged the same tax on their pass-through income.
To elect S-Corporation status, the LLC must meet the eligibility requirements set by the IRS, as mentioned above.
S Corp Status for a Corporate Entity
Under the Check the Box Rules, if an LLC chooses to be classified as a corporation, it is considered to have transferred all its assets and debts to the corporation in exchange for the corporation's stock. Then, it distributes the stock to its owners as a complete closure. This transfer to the corporation is tax-free, as long as certain conditions are met.
The LLC can also choose to become an S corporation, as long as its members meet the requirements to hold S corporation stock. (Regs. Secs. 1.1361-1(c) and 301.7701-3).
S Corp Status for an LLC Partnership
When a partnership chooses to be treated as a corporation, it is seen as transferring all its assets and debts to the corporation in exchange for stock.
It is also considered to have closed down and distributed the corporation's stock to its partners before the election takes effect.
If the conversion happens at the start of the year, it's as if the transfer and closure happened right before the previous tax year ended.
If the corporation timely elects to become an S corporation in its first year, it will be an S corporation for that year without any period as a C corporation in between.
Can An S-Corporation Own An LLC?
Yes, an S-corporation can own an LLC. An S-corporation can become a member of an LLC.
The S-Corporation can have ownership or control over one or more LLCs, treating them as separate entities.
This can be useful for structuring business operations, holding assets, or segregating different lines of business within the overall corporate structure. The S-Corporation can hold the membership interests in the LLC(s) and derive income and other benefits from its ownership.
Additionally, It can be beneficial for an S corporation to own an LLC to enjoy the advantages that LLCs provide. One advantage is that LLCs offer flexibility in distributing profits among members. If there's a situation where someone is contributing both work and money, an LLC allows for a fair sharing of profits based on their contributions.
Keep in mind that it's important to consult with legal and tax professionals to understand the specific requirements, implications, and tax consequences of these arrangements, as they can vary based on the specific circumstances and jurisdiction. It’s also important to keep in mind that S-Corp shareholders cannot be another corporation, S-Corp, partnership, or LLC. Shareholders must be an individual.
How To Choose Between An LLC And An S Corp
Assess the objectives of your business
Determine your short-term and long-term objectives, such as growth plans, financing needs, and exit strategies. If you’re considering raising capital, taking on foreign shareholders, or potentially having an income that quickly grows above $1 million then you might want to reconsider an S-Corp election. Investors don’t typically prefer investing in S-corps. Also, after so much income the benefits of the S-Corp diminish, and another entity or multi-entity structure might be more desirable.
Evaluate liability protection
Assess the level of personal asset protection you require. LLCs and S-Corps both offer limited liability, but consider the specific legal protections each entity provides in your jurisdiction.
Consider tax implications
Compare the tax advantages and disadvantages of each entity. Evaluate how pass-through taxation (LLC) or potential tax savings (S-Corp) may impact your business's financial situation and your personal tax obligations. Typically we advise clients to consider making the election once there is at least $50,000 of net income. At this level of income, the tax savings typically outweigh the additional costs associated with your increased tax preparation bill, payroll software costs, and other potential administrative costs associated with owning an S-Corp.
Examine ownership and management structure
Determine the desired ownership and management structure for your business. LLCs offer flexibility, allowing for a diverse ownership structure, while S-Corps have stricter limitations on shareholders and more formal management requirements. If you want certain shareholders to have special voting rights or other features then an S-Corp won’t work. If you plan to have foreign shareholders it also won’t work.
Assess compliance requirements
Consider the administrative responsibilities and compliance requirements associated with each entity type. LLCs generally have fewer formalities, while S-Corps have stricter compliance obligations, such as regular shareholder meetings and maintaining corporate records.
Seek professional advice
Consult with legal, tax, and accounting professionals who can provide personalized guidance based on your specific circumstances. They can help analyze the financial, legal, and operational implications of each entity type. It’s important to consider legal implications and strategy just as much as tax savings. You can shoot yourself in the foot by only considering one or the other.
Consider future scalability and exit strategies
Anticipate how your business may evolve in the future. Assess how each entity type could accommodate growth, attract investors, or facilitate a future sale or merger. Remember that an LLC can have more flexible ownership characteristics and be more attractive to investors. Also, investors might prefer a standard C-corporation over both an LLC or S-Corp in some instances. If you’re looking to run a long-term business with no exit plans as a single shareholder business then perhaps an S-Corp is desirable.
How Compass CPA PC Can Help With The Incorporation Process
This process may sound complex and difficult to understand, but you can always choose to make things easier and more convenient!
Start your journey with us here at Compass CPA PC and be able to get professional advice from our best tax accountants, who have been working on several cases and have already helped a lot of growing companies.
We will assist you in choosing the right business structure that will be in accordance with your business needs and objectives.
As we go through all the necessary information we will need, we will provide you with step-by-step guidance through the incorporation process and help you from start to finish!
As you have seen, there are several benefits and drawbacks to forming an LLC or electing an S-Corporation.
Although all this information might not be enough for your business. It will always be important to consult with professionals for personalized advice because cases could be different for every business and industry.
Making sure you are doing the right thing for your business is a must so you won’t end up losing more dollars in the future. There’s no one-size fits all.
Take the necessary steps to protect and grow your business!