On any new entrepreneur's "to do" list is to designate their fledgling company as an S corporation or a limited liability corporation (LLC).
Each business category has its pros and cons, and any decision about which direction you're heading with either an S corporation or an LLC depends entirely on your unique business needs, especially pertaining to personal finances, taxes, business operations, and government compliance.
Which one works best for you? The decision shouldn't be made until you've done a full vetting of S corporations and LLCs, and a close examination of what risks and rewards each bring to the table.
Let's break out the magnifying glass and take a closer look at both S corporations and LLCs, and examine which one makes sense for your new company.
What Are S Corporations and LLCs?
According to the Internal Revenue Service, which takes a special interest in how a business is classified, an S corporation is a business that opts to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
Basically, S corporation shareholders report the flow-through of income and losses on their personal tax returns and the IRS subsequently assesses a tax at their individual income tax rates. Under this scenario, S corporations can bypass double taxation on any corporate income earned by the business.
To get Uncle Sam's stamp of approval and achieve S corporation status, a company must meet the following requirements, as laid out by the IRS:
- Be a domestic corporation
- Have only allowable shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
All company shareholders must sign off on the S corporation application, filed via an IRS Form 2553 Election by a Small Business Corporation.
What Is an LLC?
A limited liability corporation is a relative common, uncomplicated business structure, with a strong dose of flexibility for business owners.
The flexibility in an LLC can mainly be found in numbers, as LLCs can be owned by more than one individual (the IRS refers to LLC participants as "members"), or it can be operated by a single owner (known as a "single member LLC" by the IRS.)
Structuring a business as an LLC offers ample benefits to business owners. For starters, it offers a firewall against lawsuits in protecting personal financial assets. It also curbs paperwork, stops a company from being taxed twice by the IRS, and provides some much-needed stability for new companies.
Creating an LLC is fairly basic, even by Internal Revenue Service standards. Business owners usually launching an LLC in their home states, although many business owners form an LLC in tax-friendly states like Delaware or Nevada.
Process-wise, new applications for an LLC are handled by the specific state's secretary of state office (the office's website is a great place to start your research on LLCs.) The filing form is simple and short, requiring the names of each LLC partner and their contact information. Each state has its own way of doing business, but LLC owners can count on paying a filing fee of up to $200.
Hiring a good business and/or tax lawyer isn't necessary, but for a nominal fee, it's a good idea to have an experienced hand on the till when structuring your LLC.
Tax Benefits of an LLC Filed as S Corp
There is a way to hit the "sweet spot" and benefit from both an LLC and an S corporation designation.
Business owners can do so by becoming an LLC and elect to have your business treated like an S corporation for tax purposes. Business owners need to make that call via an IRS Form 2553, but the reality is the process of balancing your company between an LLC and an S corporation is easy to do and offers some intriguing tax and operational benefits:
- Fewer headaches. Legally, the company will operate more like an LLC than a corporation when you go the Form 2553 route. That's an advantage for companies, as requirements for things like record keeping, paperwork, and regulatory mandates are eased.
- Tax benefits. In addition to fewer administrative obligations, business owners gain the beneficial tax treatments of being an S corporation. The company still gains the advantage of pass-through income and it avoids double taxation.
- Company structure. Basically, even though your company is not structured as a corporation, tax-wise, the IRS treats you as a corporation, with all of the tax benefits that designation entails.
For instance, the company is effectively split from the owner. That allows the business entity to pay ownership a salary and benefits, subject to FICA tax. Simultaneously, the business entity can steer additional net income from the business to ownership as passive income, and thus avoiding the Self-Employment Contributions Act (SECA that requires business owners at S corporations, partnerships, and sole proprietorships to pay the 15.3% net income tax from self-employment to pay for their own Social Security and Medicare.
By structuring your company as an LLC and then electing to be designated as an S corporation, business owners earn two primary benefits:
- A lower administration burden by operating as an LLC.
- Better tax benefits from electing to be an S corporation for tax purposes.
How to File as an S Corporation
While the tax form process of applying is easy (using Form 2553), The IRS has strict rules that companies need to abide by to file as an S corporation.
By and large, an S corporation will only be approved under these conditions:
- The business entity has no more than 100 shareholders.
- No business entity shareholder is a nonresident alien, i.e., a noncitizen who doesn't live in the U.S.
- The business entity has only one class of stock.
- None of the business entity's shareholders are other corporations or partnerships.
If you're applying for S corporation status for the current calendar, you must file IRS Form 2553 by March 15. Companies seeking S corporation status can elect to file IRS Form 2553 the year before an S corporation ruling takes effect.
Pros and Cons of Filing as an S Corporation
Although there are plenty of benefits of filing an LLC as an S Corporations, it isn't the best option for everyone.
Pros of Filing as an S Corp
There are some decided benefits from electing to become an S corporation. Most benefits focus on operational and tax issues - here's a quick look:
- Limited liability. Anyone affiliated with an S corporation, including business owners, partners, and staffers, all gain limited liability protection.
- Pass-through taxation. Company owners get to record any personal profit and loss on their individual tax returns.
- Elimination of double taxation of income. With an S corporation, business income can't be taxed twice - first as a tax on corporate income and secondly as a tax on dividend income.
- Investments and asset accrual. S companies can easily attract investors via the sale of shares of stock, thus adding valuable assets to the bottom line.
- Open-ended existence. An S corporation continues to exist even if the owner decides to retire or passes away.
- Once-a-year tax filing requirement. S corporations only file taxes once annually, as opposed to a limited liability company, which has to file its taxes quarterly.
Cons of Filing as an S Corp
These are some decided disadvantages of being an S corporation:
- Must be a U.S. citizen. S corporation owners and partners must be citizens of the U.S. and live here legally.
- Shareholder limits. An S corporation cannot have more than 100 shareholders.
- Higher fees. Firms that wish to elect as an S corporation often face heavier state regulation fees (depending on the state they reside) and often have to pay extra for getting help from a registered agent.
- Tax qualifications. The IRS is very strict about following the "rules of the road" on S corporation compliance. Companies have been known to have their S corporation designation taken away for not following IRS guidelines.
- Burden of business debts. Unlike a business owner operating as an LLC, S corporation ownership doesn't give you limited liability for business debts and financial obligations.
What's Better for You?
Ultimately, the choice between electing to be an S corporation or LLC comes down to your personal preference as a business owner (i.e., how you feel about tax status, compliance, and paperwork obligations.)
That said, financial issues are likely the determining factor in choosing between an S corporation and an LLC. For instance, if you want to earn a salary instead of declaring self-employment income, you want pass-through taxation, and you want to make it easier for your company to obtain investment capital, an S corporation can be a good idea.
But if you want more flexibility in operating your company and don't want the red tape associated with running a corporation, an LLC may be the way to go.
Either way, it's advisable to consult with a tax specialist and talk to business owners who have experience in both S corporation and LLC scenarios before committing to one business structure over the other.