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Should My Company be an LLC, an S-Corp or Both?

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Should My Company be an LLC, an S-Corp or Both?

By StuartR
Published: April 30, 2009 Updated: June 2, 2014

Of the many business entities that owners consider, Limited Liability Companies (LLCs) and Subchapter S Corporations (S-Corps) are two of the most popular. Although they share the distinction of being 'pass-through' entities in addition to providing liability protection, they do have several differences. An owner must also consider operational ease, administrative requirements, profit-sharing and employment tax implications.

Before choosing one or both of these options, determine which features are most important to you and your company. The needs of every business are different so it's worth an hour or two with a knowledgeable attorney to investigate all of the issues that will affect it.

What Is an LLC?

An LLC is a business structure similar to a sole-proprietorship or a general partnership. According to the IRS, 'It is designed to provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.' As a pass-through entity, all profits and losses pass through the business to the LLC owners (aka 'members'). Similar to partnerships, the members themselves report the profits/losses on their federal tax returns but not the LLC. Nevertheless, some states do charge the LLC an income tax.

What differentiates the LLC is the limit of the liability for which a member is responsible. Typically, the member's investment in the company is that limit. Conversely, a sole proprietor or the partners in a general partnership are each liable for all of the debts of the company. Keep in mind that neither LLCs nor S-Corps necessarily shield owners from their or their employees' tort actions such as accidents. Did I mention you should talk to an attorney?

Pros and Cons of the LLC

One of the features that distinguishes the LLC from an S-Corp is its operational ease. There are far fewer forms required for registering and there are fewer start-up costs. Filing taxes is a once-a-year affair on April 15: a single-member LLC files a 1040 and Schedule C like a sole proprietor; partners in an LLC file a 1065 partnership tax return like owners in a traditional partnership. Moreover, LLCs are not required to have formal meetings and keep minutes.

There are also fewer restrictions on profit-sharing within an LLC as members distribute profits as they see fit. Members might contribute different proportions of capital and sweat-equity. Consequently, it's up to them to decide who has earned what percentage of the profits or losses.

But LLCs are not the perfect entity for all businesses. First, an LLC has a limited life: when a member dies or undergoes bankruptcy the LLC is dissolved. Typically, you would determine in advance the length of the LLC's duration when you file it with your state. If your plans include taking your company public or issuing shares to your employees, essentially prolonging its life, then you would need to convert to a corporate business structure.

Second, the owner of an LLC is considered to be self-employed and must pay the 15.3% self-employment tax contributions towards Medicare and social security. As such, the entire net income of the LLC is subject to this tax. It costs money to have some operational ease!

The IRS also limits the 'characteristics' of your company. An LLC may only have two of the four characteristics that define corporations: 'Limited liability to the extent of assets, continuity of life, centralization of management, and free transferability of ownership interests.' Therefore, if you wish to have more than two of these characteristics, you'll need to convert to a corporate business structure.

What is an S-Corp?

An S-Corp is a corporation that has received the Subchapter S designation from the IRS. A business must first be chartered as a corporation in the state where it's headquartered then file to be considered an S-Corp. According to the IRS, S-Corporations are 'considered by law to be a unique entity, separate and apart from those who own it.' This allows for a limit on the financial liability for which an owner (aka 'shareholder') is responsible. Nevertheless, liability protection isn't perfect. The plaintiff may be able to 'pierce the corporate veil' and go after your personal assets in a lawsuit.

What differentiates the S-Corp from a traditional corporation (C-Corp) is the ability to have profits and losses pass through to the shareholder's personal tax return. Consequently, the business is not taxed itself, only the shareholders. There is an important caveat: any shareholder who works for the company must pay him or herself 'reasonable compensation.' Basically, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as 'wages.' We'll see the tax implications of this below.

Pros and Cons of the S-Corp

One of the best features of the S-Corp is the tax savings for you and your business. Recall that members of an LLC are subject to employment tax on the entire net income of the business. Conversely, only the wages of the S-Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a 'distribution' which is taxed at a lower rate if at all!

As I mentioned before, the shareholder must receive reasonable compensation. If you try to cheat the system by paying yourself a lower salary and higher distributions you might get a tax advantage for the year, but the IRS takes notice of such red flags. If they reclassify your distributions as wages you'll be back to paying the higher employment tax and you will have the IRS's attention. Need I say more?

Keep in mind that some benefits that shareholder/employees receive can be written off as business expenses. Nevertheless, if such an employee owns 2% or more shares, the benefits like health and life insurance are deemed taxable income.

An S-Corp also allows the business to have an independent life separate from the shareholders. If a shareholder dies, leaves the company, or sells his or her shares the S-Corp can continue doing business relatively undisturbed. By maintaining the business as a distinct corporate entity, clearer lines are defined between the shareholders and the business that improve the protection of the shareholders

The tax savings and solidity of the S-Corp also come with a price. As a separate structure, S-Corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers and records maintenance.

In addition to all of this paperwork are the tax forms required by the IRS. Such forms include:



  • Form 1120S: Income Tax Return for S Corporation
  • 1120S K-1: Shareholder's Share of Income, Credit, Deductions
  • Form 4625 Depreciation
  • Employment Tax Forms
  • Form 1040: Individual Income Tax Return
  • Schedule E: Supplemental Income and Loss
  • Schedule SE: Self-Employment Tax
  • Form 1040-ES: Estimated Tax for Individuals
  • Forms 2553, 941 and 940

These forms are due at various times during the year, so the burden to file them increases.

Also, states do not treat S-Corps equally. Most recognize them similarly to the federal government and tax the shareholders accordingly. However, some states like Massachusetts tax S-Corps on profits that rise above a specified limit. Other states don't recognize the S-Corp election and treat the business as a C-Corp with all of the tax ramifications. And if that isn't enough, some states like New York and New Jersey tax both the S-Corps profits and the shareholder's proportional shares of the profits! It pays to do your homework.

Combining the Benefits of an LLC with an S-Corp

There is always the possibility of requesting S-Corp status for your LLC. Your attorney will advise you on the pros and cons. You'll have to make a special election with the IRS to have the LLC taxed as an S-Corp using Form 2553. And you must file it before the first two months and fifteen days of the beginning of the tax year in which the election is to take effect.

The LLC remains a limited liability company from a legal standpoint but for tax purposes it's treated as an S-Corp. Be sure to contact the state's income tax agency where the election form will be filed. Ask them whether or not they recognize the S-Corp election and what the tax requirements are.

As with all of these issues, the more information you have the better. I hope this primer gives you a good starting point. For further research take a look at these websites:

SBA.gov: Business Incorporation
SBA.gov: Steps to Registering a Business
SBA.gov: Differences in Legal Structures (check out the comparisons at the bottom)
IRS: Choose A Business Structure
SBA: Choose A Structure

Message Edited by StuartR on 04-30-2009 04:53 PM

About the Author:

Comments:

I have a computer business which has been open for a year now. I just signed up to work with a company which requires me to be incorporated; either LLC (with s corp or c corp), S corp, or C corp. I became an LLC (because I was going to do this anyway) but I do not know what'll happen if I do LLC S Corp. I know I don't want to be C Corp due to the double taxation. Is it worth it to be LLC S corp? I will have/ do have people working for me as 1099, but as an LLC S Corp is it better to have them as an employee or 1099? So many questions but I don't have the money to hire an attorney. Please help. If it's too much to post on here you please email me @ kytoure@aicomputers.net. Thanks.
This is a sadly misleading and inaccurate article. S corporations are not entities and LLC's are not partnerships. Initially, (that's about 20 years ago)if an LLC wanted to be taxed as a partnership it could not have perpetual duration and many state statutes called for dissolution on death of a member (if the members did not vote to continue the entity). Corporations are entities and may be taxed: (1) under Subchapter S, or (2) under Subchapter C, of the Internal Revenue Code. LLC's are also entities and may be taxed: (1) under Subchapter S, or (2) under Subchapter C, or (3) as a partnership, or (4) as a sole proprietor/disregarded entity (if only one owner/member). Selecting the form of entity, i.e. corporation vs. LLC, involves both an analysis of the mechanics and structure of the entity as well as taxation. Most importantly, you MUST consider charging order protection offered by the LLC entity. Not to worry, Stuart, you are in a large group of people, including many CPA's who continue to confuse taxation with entity selection.
One of the points left off from this article is the disregarded entity feature of an LLC. It's an important concept for a small business currently with a sole owner. It allows you to get the liablity protection of an LLC but file your tax returns for the business as if it were a sole proprietorship. That means no federal income tax return (form 1065) is necessary for the LLC if it is a disregarded entity.
I am the owner of a small iPhone repair business www.iRepairDoc.com/iPhone-Repair/ and am uncertain if we should switch from an LLC to an S-Corp. We are interested in franchising our business too. Is there a designation that is preferable for franchising?
Franchising typically does not impact your decision on corporation vs. LLC. Your decision may be impacted by the state of your principal business location. If your are already an LLC it is unlikely that you will want to convert to a corporation. Keep in mind that LLC's AND corporations may be taxed as an S-Corp. This article is, unfortunately, very misleading. /s/ jborchers@evans-dixon.com -- www.theblogforbusinesslaw.com
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