Recently many of our clients who own small businesses have asked us about the advantages of having their businesses structured as LLC’s versus S-Corporations. Before making this determination it’s important to have a basic understanding of similarities and differences between the two.
Both provide limited liability, and help protect your personal assets from the creditors of your business. They also share the advantage of avoiding having to pay both personal and corporate taxes. An S-Corp achieves this by the owners paying themselves salaries plus receiving dividends from any additional profits the corporation may earn. An LLC also avoids double taxation by acting as a “pass-through entity,” which means that all the income and expenses from the business get reported on the LLC members’ personal income tax returns.
Some advantages of operating as an LLC include the fact that they can be fairly easy to set up, and they avoid some of the red tape involved in forming an S corp. Also, when a business has a single owner, the LLC doesn’t have to file a separate tax return for the entity, and can report the activity on their personal tax return. Both of these factors can lead to savings on accountant and attorney fees.
An LLC taxed as a partnership can also have flexibility of income distributions, and varying allocations to members. Whereas the amount of profits the S corporation’s shareholders report on their federal tax returns must be proportional to their share of stock, an LLC members can determine between themselves how to divide their income, as long as they follow the Internal Revenue Service’s rules on partnership income distribution. LLCs also do not carry ownership restrictions such as the type and number of shareholders the corporation may have, and avoid the prohibition of members being foreign nationals or from other companies.
One of the biggest drawbacks to an LLC is that active members are subject to self-employment tax on income generated by the business. Wanting to avoid self employment taxes on a portion of the businesses earnings is why many times clients consider filing as an S-Corp.
This avoidance is accomplished due to the fact that excess profits of an S-Corp are considered distributions; not subject to self employment tax. The caveat is that the S-Corp must pay its employees (including active owners) a “reasonable” salary” while also deducting payroll expenses like federal taxes and FICA .The definition of “reasonable” has been a point of scrutiny for the IRS, and should be tied to industry norms. After all salaries are paid any remaining profits from the company can be distributed to the owners as dividends, which are taxed at a lower rate than income.
As mentioned above, S-corps do have more strict guidelines than LLCs. Per the tax code, shareholders must be a U.S. citizen or resident, there can only be one class of stock, and the entity is limited to 100 shareholders. Profits and losses must be distributed to the shareholders in proportion to the shareholder’s interest, which limits the flexibility compared to an LLC.
How these pros and cons will impact your business is very important to consider as you start a new venture, or consider making a change to an existing entity. Ultimately the decision to choose an S-Corp versus an LLC should be based upon the business itself, and the objectives of its owners.
We are always happy to answer any questions you might have.