The Better Choice for Entity Selection: LLC or S Corporation?
by BarbaraWeltman, Guest Blogger
- Created: October 6, 2009, 12:40 pm
Perhaps the most popular form of business entity today is the limited liability company (LLC). According to the Fall 2008 IRS Statistics of Income Bulletin, LLCs increased by 11.3% over the previous year for a total of 1.6 million of these entities for 2006 (the most recent year for statistics). Like a corporation, it offers personal liability protection for its owners. But for income tax purposes, it is treated like a sole proprietorship if there is one owner or like a partnership if there are two or more owners (the LLC can opt for corporate tax treatment but this is seldom done). An LLC never pays taxes; instead, the owner’s share of business income, deductions, credits and other tax items pass through and are reported on the owner’s tax return.
The S corporation is another popular entity choice, offering personal liability protection and pass-through income tax treatment for owners. According to the Summer 2009 IRS Statistics of Income Bulletin, the number of S corporations was up 5.1% over the previous year for a total of 3.9 million entities for 2006 (the most recent year for statistics). S corporation income tax treatment is similar but not identical to the tax treatment for partnerships (and thus LLCs).
Both the LLC and S corporation can be used for a business that has a single owner or multiple owners. The LLC is a newer choice but has been recognized by the IRS for quite some time. Which type of entity is the better choice for you? It depends.
The nature and number of owners can impact which entity choice is preferable.
- LLCs—there are no limits on the type or number of owners in an LLC. Thus, corporations for example, can be LLC owners.
- S corporations—there are limits on the type and number of owners in an S corporation. There can be no more than 100 owners, although family members are counted as one owner. There can be no nonresident aliens as owners; only U.S. citizens and residents are permissible S corporation shareholders. There can be no corporations or partnerships as owners.
Which is better: It may not matter in most situations. However, where S corporation rules forbid a certain type of owner, the LLC allows it.
Owners can write-off business losses passed through to them from the business only to the extent of “basis.” The term has different meaning for purposes of LLCs and S corporations.
- LLCs—basis is the owner’s capital investment in the business and his or her share of the business’ debts. For example, if the business borrows $100,000 to buy property and there is one LLC member, he or she can add this $100,000 to basis.
- S corporations—basis is the owner’s basis in stock (what he or she paid for the stock) plus basis in debt (what he or she loaned to the corporation). Third-party loans to the corporation do not impact the owner’s basis. Third-party loans to the corporation that the owner guarantees become part of basis only when and to the extent the owner must make good on the guarantee.
Which is better: For businesses involving real estate investments, the LLC provides a greater basis advantage.
Owners should not only be concerned with income taxes; they should also consider the impact of entity choice on Social Security and Medicare taxes.
- LLCs—owners are self-employed individuals subject to self-employment tax (which covers both the employer and employee share of FICA for Social Security and Medicare taxes). As a general rule, owners must pay self-employment tax on their share of net earnings from the business. Some tax professionals have argued that there should be limitations on this rule for owners who are “silent partners” and who do not provide any personal services for their business. The IRS has yet to provide any definitive guidance on this point.
- S corporations—owners who work for their business are employees. FICA is imposed only on wages paid to these owners. While there may be a temptation to pay no wages since the owners must report all of their share of net income from the business for income tax purposes, the IRS says you can’t do this. Owners must receive (and pay FICA on) reasonable compensation for work performed. Making sure that S corporation owners do not skirt this rule has become a key audit target of the IRS.
Which is better: For owners who work for their business, there may be less employment tax cost with an S corporation.
State tax rules
Each state has its own rules for LLCs and S corporations. These rules impact the cost of forming the entity, the annual cost of registration to do business within the state (which can be an issue for businesses operating in more than one state), and the income tax treatment of the entity and its owners. To find the rules for your state, go to the *Federation of Tax Administrators and click on your state.
Theoretically, if you want to borrow money for a start-up or take in investors, there should be no difference between these entity choices. However, as a practical matter, the S corporation may offer an edge—this type of entity has been around longer (LLCs weren’t around before 1977)—so potential lenders/investors are more familiar with and prefer to deal with S corporations.
What do you foresee for your business? If it includes going public or taking on a large number of new owners, the S corporation may be the better choice for now. While the S corporation election will have to be terminated in order to become a publicly-held company, this is easy to do and using the S corporation now avoids the need to form a new entity.
Tally your score
Now which entity choice is better for you? Look over the various points and see which weigh in favor of which type of entity. Because of the importance of your choice of entity (you can change later on but there may be a tax cost for doing so), talk with a legal or tax advisor.
Note: You'll find another relevant resource, which was posted here on Business.gov in April.
*Hyperlink directs readers to an external Internet resource, which is a non-government Web site.
Barbara is a respected corporate speaker, contributing editor, author of more than a dozen books from major publishers, sought-after expert media source, and newsletter publisher.
About the Author
Barbara Weltman is an attorney, prolific author with such titles as J.K. Lasser's Small Business Taxes, J.K. Lasser's Guide to Self-Employment, and Smooth Failing as well as a trusted professional advocate for small businesses and entrepreneurs. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® and host of Build Your Business Radio. She has been included in the List of 100 Small Business Influencers for three years in a row. Follow her on Twitter: @BarbaraWeltman.
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