Many new business owners get excited about being their own boss and running a successful business. However, they do not think about the common pitfalls they may encounter during the startup process. Setting up the correct business structure can mean the difference of paying excess taxes or saving taxes. It’s the most important decision related to starting a business that a new business owner can make. It’s important for you to be educated on all the pros and cons so you can make the best decision and set your business up for success right from the beginning.
Onsite Accounting & Tax Services, LLC can help you:
Of the many business entities that owners consider, Limited Liability Companies (LLCs) and Subchapter S Corporation (S‐Corps) are two of the most popular. Although they share the distinction of being ‘pass‐through’ entities in addition to providing liability protection, they do have several differences. An owner must also consider operational ease, administrative requirements, profit‐sharing and employment tax implications.
An LLC is a business structure similar to a sole‐proprietorship or a general partnership. According to the IRS, “It is designed to provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.” As a pass‐through entity, all profits and losses pass through the business to the LLC owners (aka members). Similar to partnerships, the members themselves report the profits/ losses on their federal tax returns but not the LLC. Nevertheless, some states do charge the LLC an income tax.
What differentiates the LLC is the limit of the liability for which a member is responsible. Typically, the member’s investment in the company is that limit. Conversely, a sole proprietor or the partners in a general partnership are each liable for all of the debts of the company. Keep in mind that neither LLCs nor S‐Corps necessarily shield owners from their or their employees’ tort actions such as accidents.
One of the features that distinguish the LLC from an S‐Corp is its operational ease. There are far fewer forms required for registering and there are fewer start‐up costs. Filing taxes is a once‐ayear affair on April 15: a single‐member LLC (SMLLC) files a 1040 and Schedule C like a sole proprietor; partners in an LLC file a 1065 partnership tax return like owners in a traditional partnership. Moreover, LLCs are not required to have formal meetings and keep minutes.
There are also fewer restrictions on profit‐sharing within an LLC as members distribute profits as they see fit. Members might contribute different proportions of capital and sweat‐equity. Consequently, it’s up to them to decide who has earned what percentage of the profits and losses.
But LLCs are not the perfect entity for all businesses. First, an LLC has a limited life: when a member dies or undergoes bankruptcy the LLC is dissolved. Typically, you would determine in advance the length of the LLC’s duration when you file it with your state. If your plans include taking your company public or issuing shares to your employees, essentially prolonging its life, they you would need to convert to a corporate business structure or make the S‐Corp election.
Second, the owner of an LLC is considered to be self‐employed and must pay the 15.3% self-employment tax contributions towards Medicare and Social Security. As such, the entire net income of the LLC is subject to this tax. It costs money to have some operational ease!
The IRS also limits the ‘characteristics’ of your company. An LLC may only have two of the four characteristics that define corporations: ‘Limited liability to the extent of assets, continuity of life, centralization of management, and free transferability of ownership interests.’ Therefore, if you wish to have more than two of these characteristics, you’ll need to convert to a corporate business structure as well.
An S‐Corp is a corporation that has received the Subchapter S designation from the IRS. A business must first be chartered as a corporation or LLC in the state where it’s headquartered then file to be considered an S‐Corp with the IRS. According to the IRS, S‐Corporations are “considered by law to be a unique entity, separate and apart from those who own it.” This allows for a limit on the financial liability for which an owner (aka ‘shareholder’) is responsible. Nevertheless, liability protection isn’t perfect. The plaintiff may be able to ‘pierce the corporate veil’ and go after your personal assets in a lawsuit.
What differentiates the S‐Corp from a traditional corporation (C‐Corp) is the ability to have profits and losses pass through to the shareholder’s personal tax return. Consequently, the business is not taxed itself, only the shareholders. There is an important caveat: any shareholder who works for the company must pay him or herself a ‘reasonable compensation.’ Basically, the shareholder must be paid fare market value, or the IRS might reclassify any additional corporate earnings as ‘wages’.
One of the best features of the S‐Corp is the tax savings for you and your business. Recall that members of an LLC are subject to employment tax on the entire net income of the business. Conversely, only the wages of the S‐Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a ‘distribution of profits’ which is taxed at your federal income tax rate.
As I mentioned before, the shareholder must receive reasonable compensation. If you try to cheat the system by paying yourself a lower salary and higher distributions you might get a tax advantage for the year, but the IRS takes notice of such red flags. If they reclassify your distributions as wages you’ll be back to paying a higher employment tax and you will have the IRS’ attention.
Keep in mind that some benefits that shareholder/ employees receive can be written off as business expenses. Nevertheless, if such an employee owns 2% or more shares, the benefits like health and life insurance are deemed taxable income to the shareholder.
An S‐Corp also allows the business to have a separate existence from the shareholders. If a shareholder dies, leaves the company, or sells his/ her shares the S‐Corp can continue doing business relatively undisturbed. By maintaining the business as a distinct corporate entity, clearer lines are defined between the shareholders and the business that improve the protection of the shareholders.
The tax savings and solidity of the S‐Corp also come with a price. As a separate structure, S‐Corps require scheduled shareholder meetings, minutes from those meetings, adoption and updates to bylaws, stock transfers and records maintenance.
There is always the possibility of requesting S‐Corp status for your LLC. You have to make a special election with the IRS to have the LLC taxed as an S‐Corp 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. Make sure to call us before making this election so that you are aware of all the ramifications of doing so.
The LLC remains a limited liability company from a legal standpoint with the state but for tax purposes it’s treated as an S‐Corp.