Should You Form An LLC Or An S-Corp, And What’s The Difference?
Limited liability company (LLC) or S corporation (S-corp)? What do these business structures mean? As a business attorney, I always get the age-old question as to which one is best for you as a budding entrepreneur, balancing issues such as liability and taxation? Simply put, an LLC is a business structure while an S-corp is not. Instead, an S-corp is a tax election.
For a thorough analysis, you will need to consult with your business lawyer and/or accountant. But for the basics, read on:
What is an LLC?
An LLC is a business structure legally separating itself from its owner(s) (referred to as “members”).
What is an S-corp?
An S-corp indicates how a business is taxed — it is not a business structure, contrary to an LLC designation. A single-member LLC cannot be designated as an S-corp (more on this below).
What should small business owners consider before forming an LLC?
Compared to corporations, LLCs may have fewer reporting requirements and therefore be easier to manage. Typically, when individuals are deciding to form a company, they are choosing between a C corporation (e.g., Inc., P.C. etc.) and an LLC. C-corps have to file a corporate tax return and the way owners derive income is either through a distribution or W-2 salary. Owners of small businesses don’t always like this — because the C-corp gets taxed at a corporate level and then at an individual level. The reason small business owners choose to form an LLC is that the income flows through to a personal return, thereby avoiding double taxation.
While the new tax reform will have certain benefits to some businesses, including a 20% tax deduction on the income of the business, it will not benefit everyone, especially not service-based professionals like accountants, lawyers and doctors. The 20% deduction can only be used where the single filer earns less than $157,500 or $315,000 if married, filing jointly.
What should small business owners consider before designating their business as an S-corp?
To understand the answer to this question, you have to first understand how the IRS classifies businesses. The IRS defines businesses as a sole proprietorship, partnership, C corporation or S corporation. The IRS has no LLC tax designation. So, by default, a single-member LLC is taxed as a sole proprietorship while a multimember LLC is considered a partnership. The key phrase is “by default,” because an LLC can choose to be taxed as an S-corp or C-corp. If an LLC selects an S-corp designation, it may save money on Social Security taxes and Medicare.
An LLC taxed as a sole proprietorship compels the owner to 1) report business income and expenses on their personal income tax return, 2) pay personal income tax on company profits and 3) pay Social Security and Medicare taxes on said profits.
• An LLC taxed as an S-corp means the owner’s salary will be a business expense so the owner will report salary and other business profit on their personal income tax return. But, the owner will only pay taxes on their own salary (not on Social Security or Medicare).
So, what should I choose?
For most businesses, it only makes sense to register for S-corp status if you will save on taxes. To figure that out, first, identify a reasonable salary for someone with your job description. If any profit remains after paying yourself, then it is probably worth looking into S-corp designation. Just remember that your tax return will be more complex and, assuming you are the only employee, you will have to set up tax withholding.
New businesses have about 75 days after formation to elect as an S-corp. The above being said, each company is unique and circumstances different which require an analysis. Therefore, new businesses should not forgo this analysis at the outset before embarking on a venture.
As discussed, there are many similarities between LLCs and S-corps including, limited liability protection, separate entities and pass-through taxation. However, it is in the differences where an entrepreneur decides which type of company he or she prefers to start. For example, the IRS restricts S-corp ownership to 100 shareholders and U.S. citizens and/or permanent resident. Further, there are typically more formalities with S-corps, including adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings and keeping meeting minutes with corporate records. There are formalities for LLCs too, which include adopting an Operating Agreement, issuing membership shares and deciding whether it is a member-managed/manager-managed LLC — however, in my experience, LLC requirements are typically more of a recommendation than a requirement.
In order to thoughtfully perform an analysis, entrepreneurs will have to sit down with their accountant and startup lawyer to go through their goals, objectives (e.g., will there be an acquisition or merger in the future) and expected income totals to determine which type of business entity to form.