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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:

Hi TBone, There are indeed attorneys who specialize in business entities. I'm afraid I cannot recommend any on this forum, but I would search this community for members who describe themselves as business consultants and review their credentials. Also, check this blog and see if there are other members who respond to this post. Best of luck!StuartMessage Edited by StuartR on 10-09-2009 09:09 AM
I have a small business that has been pretty successful for 2 years now.  I have an accountant that helped me set it up as an LLC, but I sometimes wonder if that is the way to go.  Are there attorneys that specialize in this or is the accountant the best way to go, or a business consultant? 
Thanks for your input, Tyler. What are some of the reasons you mention above? Can you elaborate further on this thread?Thanks,Stuart
Great breakdown. If your business is really starting to succeed, there are a lot of reasons to choose different types of company's or corporations; especially for tax and liability issues. It can seem very complex, however information such as this and speaking to a certified accountant can often times simplify your understanding and help you know the decision that is right for you. Tyler GhellerLos Angeles Lawyer & Attorney Message Edited by NicoleD on 09-30-2009 12:12 PM
Hi py2, There are a few sites that I would recommend you look at to help you answer your questions: http://www.buyusa.gov/uk/en/services_for_uk_companies.htmlhttp://smallbusiness.findlaw.com/business-structures/business-structures-overview.htmlhttp://library.findlaw.com/2000/Jul/1/126394.html Please circle back and share what you find! Best of luck,Stuart
Greetings, I'm afraid this is a very specific question that you'll need to speak with your accountant about. Who advised you on election of your LLC to S-Corp? That's where I would start. Good luck!Stuart
Hello, With regard to your informative article - what would be the situation with setting up a company in the USA as a UK national? what would be the best legal body if it is possible at all - would I need to have a US partner to make this possible? It certainly seems that way... Thanks! Py2 
Hey Stuart,I clicked through because of your post title. I didn't know you could do 'both'. I think you did a great summary, but I would add this (from my limited experience :) ). It really matters what state you are in, and you should ALWAYS talk to both a business lawyer that specializes in this and an accountant. And maybe get a second opinion on that business lawyer. I've been told by about 80% of people that if you're serious, you should go inc (subchapter S)...not LLC. Steve BoothTrade Show Displays Message Edited by NicoleD on 09-30-2009 12:12 PM
Steve, Thanks so much for your input and for highlighting the fact that a person's State in very key. AND you're right on about consulting a lawyer. There's really no way around it. Best wishes,Stuart
Do you happen to know if an S-Corp is taxed similiarly to a C-Corp? Its been awhle since I have looked into this but If I remeber correctly as a C-corp the owner is double taxed once as a business tax and once for personal income.  Mike Trade Show Booths   

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