The S Corp Versus the LLC

In my previous post I advised small businesses about the upcoming March 15 deadline for S Corp election. I wanted to follow up with a more detailed look at the two most popular business entities for small businesses:  the S Corporation and LLC (Limited Liability Company).

These two entities share several key similarities. Perhaps most importantly, both will protect your personal assets from any potential liabilities of the company (whether from an unhappy customer, unpaid supplier, or anyone else who might pursue legal action). With both the S Corporation and LLC, your personal finances, home vehicles and other assets are all safe. In addition, both structures allow a business to borrow money and sell equity in order to raise capital. Both stay in existence until they are dissolved, without need for periodic renewal. And both offer pass-through tax treatment when it comes to federal income tax.

Given these similarities, how do you decide which is the better choice for your particular business? While circumstances vary among individuals and individual businesses, here are some general guidelines to help you understand the differences and their impact.

The S Corp Versus the LLC

1. Business Formality

The LLC is ideal for companies that don’t want or need much formality, but still want legal protection. In a corporation (S-Corp or C-Corp), Articles of Incorporation must be filed; bylaws have to be written; officers have to be named; a board of directors elected; and minutes must be filed and resolutions passed whenever you want to make changes to the company. In the LLC, this isn’t the case. LLCs just use an informal “operating agreement.” Depending on your particular type of business and the individuals involved, this could either be a great time and money saver, or the gateway to potential conflict down the road.

2. The S Corporation Restricts Who Can Be a Shareholder

An S Corp cannot have more than 100 shareholders (of course, this limitation is probably not of much consequence to many small businesses). All individual shareholders must be either U.S. Citizens or permanent residents. By contrast, the LLC does not have such restrictions on owners.

3. The S Corporation Has Strict Income Allocation

In an LLC, income and loss can be allocated disproportionately among the owners; in the S Corp, income and loss are assigned to each shareholder strictly based on their pro-rata share of ownership.

So what does this mean? If I own 80 percent of an LLC, my share of the tax burden doesn’t necessarily have to be 80 percent of the taxable income. But if I own 80 percent of an S-Corp and that company makes $100,000 in taxable income, I will be taxed on $80,000 of income.

4. The S Corporation Cannot Increase Pass-Through Losses

In certain circumstances, the IRS allows the loss in an S Corp or LLC to pass through to the individual shareholders. However, the LLC allows you to pass through more loss than in the S Corp, most notably when it comes to real estate. In an LLC used for real estate investments, however, the members are allowed to add the amount of the mortgage to their basis for the purpose of computing a loss. Clearly, that can add up to a significant difference in your tax statement.

5. Venture Funds Typically Do Not Want to Invest in LLCs

If your company is considering raising venture capital down the road, be advised that the C Corporation is a venture capital firm’s clear choice for the type of legal entity for their investment. Converting an LLC into a C Corp entails a complete merger and can be a rather complicated process involving accountants and possibly lawyers. By contrast, converting an S-Corp to a C Corp can be done in a day with a single tax form (you’re basically unchecking the box for S Corp tax election).

Choosing the right business structure for your business is a weighty issue and will ultimately depend on all the unique aspects of your particular business needs, vision and circumstances. But no matter what entity you choose, taking a serious look at your legal structure is important and will help you scale far more smoothly (and avoid any legal and liability pitfalls) in years to come.

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Will an LLC Help Lower Your Business Taxes?

Whether it’s driven by a desire to escape self-employment taxes or looking to avoid that “double taxation” whammy, small business owners ponder which legal structure is right for their business and financial situation.

The LLC is often associated with “pass-through taxation,” meaning the LLC itself does not pay taxes. Rather, income from the business is passed to the company’s owners (aka members) who then claim these profits on their personal tax forms.

However, the LLC actually offers flexibility when it comes to federal tax treatment. This is because the LLC is an entity created by state statute. The IRS allows the LLC to be taxed as a corporation, partnership or sole proprietor, depending on elections made by the LLC and the number of members.

Under federal law, an LLC is classified as one of these types of taxable entities:

Single-member LLC as a “disregarded entity”

In this case, you’re the sole owner of the LLC and you report business income on your Schedule C tax form, as well as pay self-employment tax on the profit on the Schedule SE form. This is what’s typically called pass-through taxation, as the LLC does not need to file any tax forms. You will only need to pay self-employment taxes if you are engaged in an active trade or business; for example, if you provide a service to clients or sell a product. If you formed an LLC for a passive activity, like real estate investments, you will not have to pay self-employment tax on the profits (and in that case, you’d report your passive profits on Schedule E).

For example, Anne is a wedding photographer and formed an LLC for her business. The LLC earned $42,000 in profit this year. She will pay taxes on this $42,000 at her individual tax rate, as well as pay self-employment taxes (currently 13.3 percent for the calendar year 2011 for the first $106,800).

Multiple-member LLC as a partnership

With this arrangement, there are multiple members who own the LLC as partners. Unlike the single-member LLC described above, in this case, the multiple-member LLC reports its business income on a separate 1065 partnership tax return. Then, each partner pays self-employment taxes on their share of the partnership profit on the Schedule SE tax form. As with the single-member LLC, self-employment taxes only need to be paid if the LLC engages in an active trade or business.

LLC as a C corporation

An LLC can elect to be treated as a corporation for tax purposes by filing Form 8832 with the IRS. In this case, the LLC files a corporate tax return 1120. And the LLC profits are not subject to self-employment taxes. However, if the LLC profits are distributed to LLC owners in the form of dividends, those dividends are taxed again at the 15 percent qualifying dividend rate. The LLC treated as a C corporation is also responsible for payroll taxes on any wages paid to LLC members who work in the business.

For example, Paul owns a consulting company which earned $80,000 in profit. As a C corporation, the business would pay $27,200 in taxes on this income (assuming a 34 perent tax rate). If Paul then takes home that profit as a dividend, he would also owe taxes (at the 15 percent qualifying dividend rate) on the dividend payment.

LLC as an S corporation

In this case, the LLC elects to be treated as an S corporation. The S corp files an 1120S tax return, but the company’s profits are not subject to corporate income tax (like they are in the C corporation). Instead, individual LLC owners are taxed on their respective shares of the company’s profits (and profits are not subject to self-employment tax). If an LLC owner works in the business, they must be paid a reasonable wage for their activities and the LLC must pay payroll taxes on these wages.

Let’s say three sisters started an organic ice cream business and each own one-third of the business. They form an LLC and elect to be taxed as an S corporation. In the first year, their business earns $90,000 in profit. The ice cream business does not pay income tax on the profit. Instead, each sister includes her share of the profit ($30,000) in her taxable income on her individual tax return. And if their business lost $45,000 in the first year, each sister would include a $15,000 loss in her individual taxable income.

Choosing the right tax entity for your LLC is a weighty issue and will ultimately depend on all the unique aspects of your particular business needs, vision and circumstances. Investigate your options and stay on top of changing tax developments on both the federal and state levels that could affect your taxes.

Most importantly, know that the LLC is great for small business owners who want liability protection, but would prefer minimal formality (and paperwork). It’s also a perfect structure for a business with foreign owners, as anyone (C corp, S corp, another LLC, trust or estate) can be an owner of an LLC. So take some time and educate yourself on the benefits of forming an LLC and what tax treatment is best for you. After all, both you and your business are worth it.


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More in: Incorporation

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