In the challenging, yet rewarding, journey of entrepreneurship, deciding on the business structure serves as the first critical crossroad. A decision that not only affects your company’s legal and operational aspects but also influences its taxation, compliance requirements, and even your personal liability. As an entrepreneur, you need to choose wisely between the two popular choices – a Limited Liability Company (LLC) and an S Corporation (S Corp). This article is designed to help you navigate this decision, shedding light on what each of these structures entails and how they could impact your business journey.
Understanding the Basics – What is an LLC?
A Limited Liability Company, abbreviated as LLC, is a unique business structure that blends elements of partnership and corporate structures. The chief allure of an LLC lies in the ‘limited liability’ it offers to its owners, often called ‘members’. This means that members are not personally liable for the company’s debts or liabilities. Any legal issues or financial debts are restricted to the business, protecting the members’ personal assets.
In terms of taxation, an LLC typically operates as a pass-through entity. The business itself is not taxed, but the profits ‘pass through’ to the members who then report this income on their personal tax returns. This avoids the double taxation that traditional corporations face. However, LLC members must pay self-employment tax on this income. If required, an LLC can choose to be taxed as an S Corp, adding another layer to the flexibility of LLCs.
What is an S Corp?
An S Corporation, or S Corp, is a specific type of corporation created through an IRS tax election. A distinct feature of the S Corp structure is that it avoids double taxation, much like an LLC. This is achieved by allowing profits (and some losses) to be passed directly to the owners’ personal income without federal corporate tax.
Owners of an S Corp, called shareholders, consider themselves employees and receive a salary from the business. S Corps have certain restrictions: they must have one to 100 shareholders, be based in the U.S, and file as an American corporation.
LLC vs S Corp
To make an informed decision about your business structure, it’s vital to understand the nuances that differentiate an LLC from an S Corp.
LLC members are required to pay self-employment taxes, which include Social Security and Medicare taxes, directly to the IRS. On the other hand, in an S Corp, the corporation pays the business owners’ (or shareholders’) payroll taxes, which are deducted as business expenses. The remaining profits are distributed as dividends, which often have a lower tax rate than income.
In an LLC, members have flexibility in managing the company. If managed by members, an LLC operates much like a partnership or a sole proprietorship. Conversely, if the LLC hires managers to oversee operations, it functions more like a corporation.
S Corps, in contrast, usually have a more formal management structure with directors and officers. The board of directors oversees the overall corporate decisions, and officers manage daily operations.
Shareholder and Stock Restrictions
In terms of ownership, an S Corp can’t have more than 100 shareholders and doesn’t allow non-U.S. citizens as shareholders. Conversely, an LLC can have an unlimited number of members, including non-U.S. citizens.
There are also differences in stock issuance. S Corps can issue one class of stock, whereas LLCs do not issue stock at all.
The Final Choice – LLC or S Corp?
The choice between LLC and S Corp depends on multiple factors such as business goals, the number of owners, potential investors, and future growth. For simplicity and flexibility, an LLC might be the best choice, especially for small businesses and startups. However, as your business grows and the self-employment tax burden increases, an S Corp may become a more attractive option, offering potential tax savings and increased credibility.
While an S Corp might sound financially beneficial, it may not be the best option for a single-member LLC due to its stricter regulations and operational requirements. In contrast, an LLC offers business owners greater flexibility.
Making the Switch Between an LLC and an S Corp
One of the flexibilities that come with owning a business is the ability to modify your business structure as it evolves. In other words, a business can switch between an LLC and an S corp. Intriguingly, your business can carry both tags simultaneously. Your LLC status at the state level doesn’t disappear simply because you’ve chosen to be an S corp at the federal level for tax purposes.
However, changing your mind and revoking your S corp status after election does come with its share of paperwork. It’s therefore advisable to make a firm decision to avoid the bureaucratic hoops that can accompany indecisiveness.
Now, let’s delve a little into the realm of certifications and what they mean for your LLC or S corp.
Here, it’s essential to consider the role of C corporations. C corps, under Subchapter C, are distinct taxable entities. They file their taxes using Form 1120. If a business wishes to transition from an LLC or a C corp to an S corp, they need to file Form 2553 with the IRS, ensuring that the business complies with all Subchapter S guidelines.
LLC owners must file their paperwork with the state where the LLC was formed. Note that these requirements differ from state to state. Most states mandate some form of public notification, which can potentially be quite costly depending on your jurisdiction.
For S corps, there’s a need to file articles of incorporation in the state where the business intends to incorporate. Additionally, holding an annual shareholder meeting and fulfilling additional state reporting requirements are also part of the S corp package.
Should You Have Your LLC Taxed as an S Corp?
Determining the right structure for your business is highly dependent on your business needs, your co-owners (if any), and the nature of your business. However, it’s crucial to understand the pros and cons associated with having your LLC taxed as an S corp.
The main advantages of having your LLC taxed as an S corp include:
- Your business handles your salary and its payroll taxes. This could potentially save you money on taxes, as you would ordinarily pay self-employment taxes on your business’s gross income as a regular LLC.
- Any additional earnings are disseminated to shareholders as dividends. This can lead to further savings since dividends are taxed at a lower rate than regular income.
However, there are also downsides to this approach:
- There is a salary cap: reasonable compensation must be set for owner-employees.
- You are limited to one class of stock and 100 shareholders.
- Shareholders who own more than 2% of the company’s stock can’t claim employee health insurance as a tax-free benefit, as they could with a C corp.
According to Scott Royal Smith, founder and CEO of Royal Legal Solutions, once your business hits the $60,000-a-year mark, having your LLC taxed as an S corp becomes a wise move. This enables you to separate the income between personal income and dividend income, potentially leading to a lower overall tax rate. However, remember that you also have to pay for an individual S corp tax return at this point.
Can an LLC purchase a membership interest in an S corp?
The short answer to this question is typically, no, although there can be exceptions. The ownership stake in an LLC is called a membership interest, while owners in an S corp are known as shareholders.
Shares or stock denote a shareholder’s interest in a corporation. In situations where the corporation does not issue stock certificates and merely documents the distribution of shares on paper, an LLC that wishes to acquire an interest in an S corp would need to purchase shares, not a membership interest.
An LLC with more than one member is generally barred from purchasing or owning S corp stock as it breaches Subchapter S guidelines. However, an exception can be made for a single-member LLC taxed as a disregarded entity, though this situation is rare.
Starting as an LLC vs. an S corp
Many entrepreneurs kick off their ventures as LLCs, primarily due to the legal protection it provides for their personal assets. However, as your business grows, it could be advantageous to consider filing as an S corp due to the financial benefits.
To stay in compliance with your state’s laws, you should also determine the number of investors, stock classes, and foreign owners who will be members of your LLC.
While making these decisions, keep in mind that these are not cast in stone. With the flexibility that LLCs and S corps offer, you can adjust your business structure as your venture grows and its needs evolve. Always consult with your CPA or a trusted legal advisor to make the best decision for your business.