No matter what type of business you run, at some point you will probably have to decide whether to structure your enterprise as a Limited Liability Corporation (LLC) or an S-Corp. Both have a number of similarities and differences which can make the decision particularly difficult. The choice between LLC and S-Corp can have a lot of financial and accounting ramifications, so a wise choice is necessary.
While there is no one-size-fits-all approach to choosing between the two, the following items can help you learn the difference between the two.
How a Legal Entity Affects Your Business
The legal entity that you choose for your business has a significant impact on your business. It affects your exposure to liability as well as how your business is taxed. Your choice of business structure also affects important issues such as financing, growing your business, number of shareholders and the way in which business functions are performed. Choosing your legal entity is an extremely important decision that requires serious consideration.
Limited Liability Corporations (LLC)
Limited Liability Corporations are easy to start and run and they generally require minimal upkeep to keep them compliant. LLCs protect your personal assets against debts, losses as well as court rulings against your business. They are generally set up as pass-through entities which makes dealing with taxes a breeze. There are several options on how an LLC is taxes, so it is very important to discuss these issues ahead of time with your attorney and accounting so that you do not have surprises at year end.
If the LLC is owned by one person, the single member LLC (SMLLC) is disregarded as an entity for purposes of taxation. Taxes for a SMLLC are paid on the owner’s personal 1040 tax return based on the income reported on a Schedule C. But if the LLC is owned by two or more individuals or separate business entities, the LLC is treated as a partnership for tax purposes. The LLC will file a separate tax return (Form 1065) as a partnership, and the income or losses are reported by the individual owners. The owners of a SMLLC or a partnership LLC are not employees of the company, so cannot take a salary from the company, but instead take draws against available cash. The owners are taxed on the full value of the net income, regardless of whether they take money out of the company.
The LLC can also choose to be taxed as a corporation, or S corporation. Under this structure, the owners would also be set up as employees of the company. Again, the LLC files a separate tax return to report income and losses. If electing S-Corp status, the income flows through to the owners of the LLC, and the taxes are paid by the owners on the net income. The chief tax advantage of the S-Corp status over the partnership status is the reduction in the amount of Medicare tax paid by the owners. However, the partnership has more flexibility than the S-Corp in profit allocations when there are multiple owners.
It’s important to note that not all debts and liabilities belong to the LLC. Any credit or loans obtained with your social security number or personal financial information will remain your responsibility, even if your LLC can’t pay them back.
S-Corps have a number of advantages as well. Much like an LLC, personal assets are generally protected. In fact, only money invested by shareholders is at risk, except in extreme circumstances. S-Corps are also pass-through entities. The corporation is not taxed but the shareholders are. One benefit of S-Corps is that the owners of the company will also draw a salary and receive a W2 at year end. Another benefit is that S-Corps can sell stock in the company while LLCs can only sell a membership interest in their company.
S-Corps have an extremely rigid management structure with strict rules and lots of paperwork. Failure to maintain corporate formalities can result in several tax ramifications. It can also lead to your business being barred from using the S-Corp election for five years.
Before choosing your legal entity, it’s important to consider state-specific tax information. Burdette Smith & Bish can help! Please contact us for details.