You finally a business owner, or maybe you have been running one as a sole proprietor, even moonlighting on the side, and have decided you need to protect your personal assets from those involved with your growing business. You might even decide that there could be a tax break in it for you. Whatever your reasoning, you’re likely contemplating a choice that many entrepreneurs face: Should your enterprise be structured as a limited liability corporation (LLC) or an S corporation (S corp)? These two organizational forms have similarities and differences–which can make choosing between them and others, like a C corporation (which includes publicly-held companies), confusing at best. Each state might also have different rules that come into play. That’s why you’ll want to get some input from a respected accountant and/or attorney to help you decide what might be the best fit for your business.
Defining the Benefits
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.” “If you put in $10,000, and incur $11,000 in debt, you’re only potentially liable for $10,000. Your creditors can’t ‘pierce the corporate veil,’ as the phrase goes.”
Another common aspect of LLCs and S corps is that they help you avoid paying both personal and corporate taxes. The difference is that in an S corp, owners pay themselves salaries plus receive dividends from any additional profits the corporation may earn, while an LLC is a “pass-through entity,” which means that all the income and expenses from the business get reported on the LLC operator’s personal income tax return.
Both LLCs and S corps can also deduct pre-tax expenses, such as travel, uniforms, computers, phone bills, advertising, promotion, gifts, car expenses, and health care premiums, McFarlane writes.
Note the Differences
Once you understand the benefits that come from LLCs and S corps, it’s time to explore some of the pros and cons of each approach. Here are some of the key differences.
- The owner of a single member LLC doesn’t have to file a tax return for the LLC, as they only report the activity on their personal tax return.
- Ease of setup: Most LLC forms are only a single page for single member LLCs.
- Inexpensive to start: The cost of setting up an LLC is also inexpensive, usually just a couple hundred dollars.
- Guidelines: The red tape involved in forming an LLC isn’t as stringent as that involved with S corps, which also leads to savings on accountant and attorney fees, among others.
- Self-employment tax: Single member LLC owners are required to pay self-employment tax on income generated in the LLC, which means making quarterly estimated payments to the IRS.
- Owners of LLCs must make sure they don’t pierce the “corporate veil,” meaning they have to operate the LLC separately from their personal affairs.
S Corp Pros:
- The key advantage of an S corp is that it offers tax benefits when it comes to excess profits, known as distributions. The S corp pays its employees a “reasonable” salary, which means it should be tied to industry norms, while also deducting payroll expenses like federal taxes and FICA. Then, any remaining profits from the company can be distributed to the owners as dividends, which are taxed at a lower rate than income.
S Corp Cons:
- S corps have more strict guidelines than LLCs. Per the tax code, Eka says, you must meet the following standards to create an S corp:
- Must be a U.S. citizen or resident.
- Cannot have more than 100 shareholders (a spouse is considered a separate shareholder for the purpose of this rule).
- 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.
- It costs more to form an S corp.
- Shareholders must adhere to the requirements at all times. If they don’t, they risk disallowing the S corp election, and the corporation would be treated as a C corp with its corresponding restrictions.
- Passive income limitation: 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.
- Shareholders should pay attention to paying themselves a “reasonable” salary for the work they perform for the S corp, since the IRS is increasingly scrutinizing S corps for this.
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