LLC or S Corp?

This week I had a question arise with a client forming a new entity... What, exactly, are the differences between an S Corporation and a Limited Liability Company? And why would I choose one over the other?

Corporations and LLCs are both great business structures because unlike sole props and partnerships, they offer liability protection for owners. Meaning that the owner of a business cannot be held personally responsible for the company’s debts and their personal assets are shielded.

S corps and LLCs are both considered “pass-through” entities for tax purposes, so the income of these companies are reported on the owners’ personal income tax returns and the issue of double taxation is eliminated (the company doesn't pay income tax and then distribute dividends to owners who also pay personal income tax on the money).

So what are the differences between an S corporation and an LLC? To sum up, an LLC is your best option if flexibility and minimizing paperwork are important to you. If however; you want to reduce employment tax, an S corporation could work better.

Let's start with S corps... An S corporation can have no more than 75 shareholders (the legal label for owners). An S corporation is operated in the same way as a traditional C corp and has to adhere to all the same regulations and bookkeeping procedures. None of the shareholders can be nonresident aliens or other corporations or LLCs. The directors or officers of an S corp manage the company and they have no flexibility in how profits are split up. The profits must be distributed according to the percentages of stock ownership, even if the owners have some justification for distributing the profits differently.

Now for LLCs... LLCs offer greater flexibility in ownership and simplicity of operation. There are no restrictions on the ownership of an LLC, and Limited Liability Companies are not subject to the plethora of formalities by which S corps must abide. An LLC can be member-managed (meaning that the owners actually run the company) or it can be manager-managed by non-owner staff with designated responsibility for operations.

The primary factor that differentiates an S corporation from an LLC is the employment tax that owners pay on earnings. In an S corporation, only the salary you pay yourself as an employee-owner is subject to employment tax. The remaining income you get as a distribution is not subject to employment tax under IRS rules. The owner of an LLC is considered to be self-employed by the IRS and must pay the going “self-employment tax” rate of 15.3% which is their contribution to Social Security and Medicare. Typically in an LLC the entire net income of the business is subject to self-employment tax which can mean a much higher total tax bill.

Here's an example:

Let's say you own florist and you are an S corp. According to the industry standard, you pay yourself a salary of $35,000. But the company earns additional profits, so your total for the year is $60,000: $35,000 in salary and $25,000 as a distribution from the S corp. This means your employment tax is $5,355 (15.3% of $35,000). If you were structured as an LLC, you would have to pay employment tax on the entire $60,000, equaling $9,180, so by operating as an S corporation you save $3,825 in employment tax.

A word of caution! You may be getting excited about the option of jacking up your salary to cover most of the distributions you will receive and saving a ton of money, but the IRS is careful to notice whether a salary is 'reasonable' by industry standards. If they decide your salary is out of line, the IRS will reclassify some of it. :(

In summary, while the potential employment tax savings may make the S corporation an attractive structure, you will have to deal with all the paperwork associated with payroll tax and you'll have to 'pay-as-you-go' throughout the year. Paperwork can be time-consuming and annoying if you are only doing it for yourself and not for an entire staff. You also can't postpone tax payments to cover a cash crunch or balance out losses. Owners of LLCs pay their self-employment tax once a year with their income taxes. Income tax filings are simple for an LLC and work like sole proprietorships or partnerships.

Bottom line... there is no one perfect business structure for every situation and you have to decide what your priorities are. Visit the SBA to learn more about the options for structuring your new business, and talk to your CPA or tax attorney to get professional help in choosing the right structure for you.