Many business owners structure their companies as S corporations or limited liability companies (LLCs). On the surface there are several similarities. Both types of entities avoid corporate income tax. Instead, business income is taxed only once, on the tax return of the S corporation shareholder or the LLC member. Moreover, both S corporation shareholders and LLC members have limited liability: their financial exposure from the company’s operation generally is no greater than the amount they invest and any notes they personally sign. (In exceptional circumstances, creditors may gain access to additional personal assets of the business owner.) Nevertheless, there are differences between the two structures, which you should consider when choosing between them.
Looking into LLCs
In some ways, an LLC resembles a sole proprietorship or a partnership, but with the advantage of limited liability. Usually, you can form an LLC with relatively little paperwork. Once an LLC is operating, there may be few tax returns to file and other recordkeeping and reporting requirements for LLCs are generally less burdensome than for corporations. If an LLC has multiple members, the business has a great deal of flexibility in how any profits are distributed among them. A downside is that an LLC may have a limited life. Depending on state law and the operating agreement, the death of a member may dissolve the LLC, for instance. In addition, taxes might be relatively high for LLC members. That’s because all net income of the LLC is passed through to members as earned income on their personal tax returns, per the LLC agreement. The members are treated as if they were self-employed; they owe the employer and employee shares of items such as Social Security and Medicare tax, with a relatively small deduction as an offset.
Considering S Corps
Even after making an election to be taxed under Subchapter S of the Internal Revenue Code, an S corporation is still a corporation. There are meetings that must be held, minutes that must be kept, and extensive paperwork to process. Such efforts can be time consuming and expensive. In addition, S corporations must meet certain requirements. A business with more than one class of stock or a shareholder who is not a U.S. citizen or resident can’t be an S corporation, for example. Similarly, an S corporation can’t make disproportionate distributions of dividends or losses. On the plus side, S corporation shareholders can receive a salary, on which they owe payroll tax, and dividends, on which they don’t. Although artificially low-balling a salary will draw the ire of the IRS (see the August 2014 issue of the CPA Client Bulletin), S corporation owners may pay thousands of dollars less per year in payroll taxes than LLC members pay on similar company related income. What’s more, S corporations can be longlived, and this permanent nature may make them more attractive to lenders and investors than potentially short-lived LLCs.
Choosing or combining
Your choice of business structure may come down to whether you prefer the simplicity and flexibility of an LLC or the potential tax savings and lender and investor appeal of an S corporation. State laws vary, so a tilt in one direction or another may influence your decision. Yet another possibility is to set up your business as an LLC and then request S corporation taxation by filing IRS Form 2553, “Election By A Small Business Corporation.” Our office can go over your specific circumstances to help you decide how to structure your company.