Choosing a business structure can be unnerving for the new business owner. After all, your business structure affects how you pay your taxes, how you pay yourself, and how much paperwork you have to deal with.
Two of the most popular legal structures for small businesses are the LLC (Limited Liability Company) and the S Corporation. These two structures are favorites among accountants and small business owners alike because they offer “pass-through” tax treatment. Unlike a regular C Corporation, LLCs and S Corporations do not have to pay taxes on the business’ profits. Instead, any profits are passed through to the business owner(s) and reported on their individual tax returns.
In addition, both of these structures provide liability protection for the business owner, by separating the owners from the business. So, if your business should be sued or can’t pay its bills, you may not need to pay from your own personal assets (like you would if your business was a sole proprietorship).
So, the question is: which structure is right for your small business…the LLC or S Corporation? Here is a break down of some of the basic differences between these two structures:
1. Paperwork and administration. From a paperwork and administration standpoint, an LLC is typically much easier to run than an S Corporation. That’s because an S Corporation still demands all the formalities and compliance obligations of a regular C Corporation…i.e. board of directors, shareholder meetings, meeting minutes, and other documentation. In most cases, the LLC involves fewer state filings and forms, and has lower start-up costs. This can be an important factor if you want to keep your paperwork to a minimum.
2. How you allocate your profits. This difference will matter only if the business has multiple business owners. Let’s say you launched a business with a friend or family member and you each own 50% of the business. Then, during the second year of business, your partner wasn’t able to spend as much time on the business, so you both decide that it would be fair for you to keep 75% of the profits for the year.
The S Corporation doesn’t give you much flexibility for these types of arrangements. With the S Corporation, you’re going to be taxed strictly based on the percentage of ownership. In the example above, both you and your partner will need to pay taxes (on your individual return) on 50% of the business’ profits each year. But, the LLC lets you decide how you want to divvy up the profits and you can be taxed accordingly. Again, if you’re the sole owner of the business, this difference won’t matter, but for others it can have a big impact on taxes.
3. Eligibility. It’s important to realize that not every business can qualify as an S Corporation. For example, an S Corporation cannot have more than 100 shareholders. And all shareholders need to be legal residents of the U.S. and need to be individuals (i.e. a partnership or corporation can’t be a shareholder of an S Corporation). The LLC doesn’t have these kinds of restrictions.
4. Self-employment taxes. If you have been self-employed or the owner of a sole proprietorship for awhile, then you’re already familiar with self-employment taxes. Here, the S Corporation gives you a little more flexibility in how you can pay yourself, and in some cases, this can lower what you pay in self-employment taxes.
With an LLC, all of your net earnings are subject to self-employment tax for social security and Medicare. However, with the S Corporation, you can divide up the earnings into salaries and then passive distributions. The salary part is subject to FICA tax for social security and Medicare, but the distributions are not. Of course, the IRS requires that you pay yourself a fair market salary, and they will check this.
The two aren’t mutually exclusive. The interesting, and often misunderstood, detail is that these two business structures aren’t mutually exclusive. It’s actually possible to form an LLC for your business, and then elect to have it treated as an S Corporation by the IRS. In essence, this can give you the best of both worlds: you can get the flexibility and simplicity of the LLC, but then also be able to pay yourself with salary and distributions.
If you want to incorporate a business and file to be treated like an S Corporation, then you’ll need to get your paperwork in (its IRS Form 2553) within 75 days after your LLC has been formed. If you’re already too late, don’t despair: you can still send in your form at any time, and it will apply for the next tax year.
The right decision ultimately depends on all the unique aspects of your situation. But regardless of which business type you choose, take a serious look at your legal structure in order to create a strong foundation for your business.
“Solution” courtesy of ddpavumba / www.freedigitalphotos.net
About the author: Nellie Akalp is a passionate entrepreneur, small business advocate and mother of four. As CEO of CorpNet.com, a legal document filing service, Nellie helps entrepreneurs start a business, Incorporate, Form an LLC, or set up Sole Proprietorships (DBAs) for a new or existing business.