What Entity Should I Use an S Corporation or LLC?
For most small businesses, the choice is pretty simple, you should have a separate entity to shield your personal assets from liability. In most cases, you should use an S corporation or an LLC (Limited Liability Company).
Why? Because both give you the corporate shield from liability with only one level of tax. In addition, you may be able to benefit from losses.
The decision from there becomes more nuanced and complicated.
C corporations have two levels of tax and partnerships can have liability shield issues and are generally more complex. So these entities are generally not the best choice for most businesses. You might have noticed that all of the big accounting and law firms converted from partnerships to LLC's in the past 10 years.
However, C corporations are often used for investments where the potential exit is an IPO or where the investors are Venture Capital or Private Equity since they are easier to cash out of.
S Corporations are the first choice of most business owners.
Why? Because they are similar to an LLC and you can avoid some of the self employment tax. At 15.3%, the avoidance of this tax is a big deal.
There are some basic advantages of the S-corporation from a tax perspective.
First it is considered a disregarded entity for income tax payment purposes meaning there is no income tax liability at the corporate level. The ordinary business income (or Loss) as well as several other ‘things' pass directly through to the shareholders via IRS Form 1120-SS Schedule K-1 and are subject to federal income taxation at the shareholder's personal tax rate.
Second, it offers tax benefits when it comes to profits. The S corp pays its employees a "reasonable" salary, which means it should be tied to industry norms, while also paying payroll expenses like federal taxes and FICA. Then, any remaining profits from the company can be distributed to the owners as dividends, which escape the self employment tax at 15.3%.
The main disadvantage of an S-corporation, from a tax perspective, is that any distributions made to multiple shareholders must be made on a pro rata basis at the same time. This basically means that you can't do a lot of fancy stuff. So a S-corporation structure does not work well in situations where there are capital contributions to the S-corporation that are to be repaid on a non-pro rata basis.
A second disadvantage of an S-Corp is that if you aspire to experience substantial growth and attract major investors the S-Corp is limited to 100 shareholders. A third disadvantage is that appreciated assets distributed from the S-corporation to its shareholders can result in a 35 percent tax on the appreciation. That means that S-corporations are rarely a good vehicle for ownership of real estate as real estate continually seems to appreciate.
S corps have more strict guidelines than LLCs. They cost more to form and have more annual paperwork for administrative and tax purposes.
S Corporations have a variety of restrictions, but most are not show stoppers. Shareholders must be a U.S. citizen or resident. It cannot have more than 100 shareholders. The S Corporation can only have one class of stock. Profits and losses must be distributed to the shareholders in proportion to the shareholder's interest. For example, you can't have disproportionate distributions of dividends or losses. If a shareholder owns 10 percent of the S corp, he or she must receive 10 percent of the profits or losses. You can't have more than 25 percent of gross receipts from passive activities, such as real estate investment. There can be additional state taxes for S corps.
LLCs are the second main choice of owners to establish a business. The main advantage of an LLC is the simplicity in taxation since the entity is taxed as a partnership using IRS Partnership Form 1065, unless of course you are a single member LLC or a husband/wife LLC in which case the income is reported on IRS Form 1040 Schedule C essentially being treated as though you were a sole proprietor.
Another main advantage however, is unlike the S-corporation's disadvantage of equal pro rata distributions, LLC distributions to the owners can be structured in any way that meets the economic agreement among the owners as long as those distributions otherwise have substantial economic effect which essentially means that any tax deductions taken must be supported by economic arrangement of the members. If two owners were opening a consulting practice and one owner was providing the initial capitalization and the other was going to run operations, the LLC could allow for initial distributions solely to the member providing the initial capital so as to return his capital as soon as possible. Then after member's return of capital, there could be equal distributions of cash to the members. This is not something you could accomplish in an S-corporation.
A third advantage of an LLC is that it is much more difficult for a creditor to obtain an interest in an owner's ownership position in the business. Creditors more than likely would receive what is simply called a Charging Order, which provides that the creditor is entitled only to receive any distributions of cash or property that would otherwise be made to the owner. This provides for continuity of ownership of the business should one owner get into financial problems outside of the business.
The biggest disadvantage of an LLC is that in most cases all profits are subject to both income tax and self-employment tax.
Regular or C-corporations on the other hand are subject to income tax at the corporate level. If the shareholder wants to pull cash out of the C-corporation they must do so generally speaking either as wages (subject to employment tax); as a dividend paid out of after tax corporate profits (and subject to another level of income taxation again at the shareholders marginal income tax rate); or, as a return of capital subject to capital gain taxation on gains or capital loss limitations on losses. Income of the S-corporation is reported to the shareholder irrespective of whether the revenues are distributed in whole or in part to the shareholder. This is where many people get confused as many S-corporations report ordinary business income but do not distribute cash to shareholders. Particularly when an S-corporation aspires to grow there is a built in predisposition to reinvest all spare cash in organically acquiring property or equipment. The other tax advantage of an S-corporation is that as long as the owners who work in the business pay themselves a reasonable salary, any extra revenue of the S-corporation can be distributed to the shareholder without imposition of self-employment taxes, but is still nevertheless subject to income tax at the shareholders marginal tax rate. Another area where many people get confused is the fact that self-employment taxes are separate and distinct from employment taxes which are also separate and distinct from income taxes.
Protection From Creditors
A major advantage of organizing your business as an LLC or an S corp is that you can protect your personal assets from the creditors of your business. "Limited liability means you can't be financially responsible for more than your investment in the company. However, corporations cannot shield you from professional malpractice so doctors and lawyers have to consider some other asset protection measures too.
An LLC can be an S Corporation Too
Ok, we are going to get fancy here.
For tax purposes, by default, an LLC with one member is treated as a sole proprietorship. By default, LLCs with more than one member are treated as partnerships. However, an LLC can elect to be treated as an association taxable as a corporation by filing Form 8832, Entity Classification Election. And, once it has elected to be taxed as a corporation, an LLC can file a Form 2553, Election by a Small Business Corporation, to elect tax treatment as an S corporation.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.
A C corporation offers one major tax advantage over LLC and S corporation pass-through taxation: it may provide certain fringe benefits to employees that are excluded from the taxable income of the employee but are still deductible as expenses of the corporation. The following are some of the fringe benefits recognized by the IRS:Accident and health benefits;Adoption assistance;Dependent care assistance;Group-term life insurance coverage; and Health savings account contributions
While the S corporation tax classification would avoid the double taxation issue, it would not allow the S Corporation members to enjoy the fringe benefits tax advantage because employees in an S corporation who own 2% or more of the corporation stock must still report the value of the fringe benefits they receive as taxable income and pay tax on this value. There is a similar rule for LLC's.
Whew, that was hard and there were a lot of considerations to take into account.
My Recommendation is that most businesses incorporate as S-corporations. They get the liability shield, one level of taxation, minimized self employment tax and better fringe benefits.
However, if the company is going to hold real estate or there are complex profit or loss sharing arrangements, I'd recommend the LLC.
While these are general guidelines, every situation is different and should be carefully analyzed for its unique circumstances. In addition, once you chose your entity and incorporate, it can be administratively difficult and costly from a tax perspective to change it. So use a lawyer and make the right choice the first time.
Connecticut and New York often have unique laws which require special planning. So whether you will operate in Westport CT or Lewisboro NY makes a difference.