Should You Set up Your Business as an LLC or an S Corporation?
Choosing the right business type is essential to your company’s success.
- What structure a business owner wants to incorporate their company under is among the first choices they must make.
- All LLC owners’ income is subject to self-employment taxes. If S corp owners pay themselves a “reasonable salary,” they may pay less of this tax.
- While S companies are restricted to 100 stockholders, LLCs can have an infinite number of members.
- This article is for business owners who are selecting between an LLC and a S corporation as the legal form for their company.
You have a variety of business entity kinds to select from when forming a company. S corporations and limited liability companies (LLCs) are both common possibilities, although they have significant differences, including tax laws and organizational structures. A company may occasionally be both an LLC and a S corp. Before deciding which is best for your company, you need be aware of the distinctions between different business forms.
What is an LLC?
The owners of a corporation, referred to as “members,” might protect their personal assets by forming a limited liability company (LLC). Imagine if the company faces legal issues or a lawsuit from a debt collector. In that situation, the plaintiff or creditor is only able to seize the assets of the company and not the personal property of the LLC members.
The LLC benefits from being a pass-through entity, which means that its profits “flow through” the company to the LLC members, if it is taxed as a sole proprietorship. Instead of submitting a company tax return, they can record the earnings on their individual tax taxes. On their income, the LLC members are required to pay self-employment tax.
Another option is for an LLC to be taxed as a S corporation; in which case the member must get a fair pay. Payroll taxes are subtracted from the LLC’s report of the owner’s compensation as a business expenditure. Dividends are paid out from any residual corporate earnings.
What is an S corp?
A tax choice known as a S corporation, also known as a S corp or a S subchapter, informs the IRS that your company should be taxed as a partnership. Additionally, it avoids corporate-level double taxes for your company. Your company must first file as a C corporation or an LLC in order to become a S corp.
The shareholders of a S corp are the company’s owners. Since you are the company’s owner, you are required to pay yourself a fair income. Profits, losses, credits, and deductions of a S company are taxed at the shareholder level.
Your company can have one to one hundred shareholders and yet be considered a S corp. Additionally, you must register as an American corporation with the IRS and have your company’s headquarters in the United States.
What is the difference between an LLC and an S corp?
Because an LLC gives greater flexibility than a corporation form, small company owners frequently choose for this structure. But it’s necessary to understand the distinctions between LLCs and S corporations before you make this crucial choice.
Social Security and Medicare taxes, which are self-employment taxes, must be paid by LLC members directly to the IRS. Although these tax rates are subject to annual adjustment, the IRS estimates that the self-employment income tax rate in 2022 will be 12.4% for Social Security and 2.9% for Medicare. Any revenue that an LLC earns is regarded as taxable revenue.
In a S corp, shareholders get salaries, and the firm covers their payroll taxes, which are deductible from the company’s taxable income as a business expenditure. If a company has excess earnings, those surplus profits are paid to shareholders as dividends, which are taxed at a lower rate than ordinary income.
According to Guy Baker, the CEO of Wealth Teams Alliance, LLCs and S corporations have different management structures.
When managed by members, an LLC resembles a partnership or a sole proprietorship if there is just one member, according to Baker. The LLC will more closely resemble a corporation if it is managed by managers because members won’t be involved in running the company on a daily basis.
A board of directors monitors corporate formalities and important decisions, while the directors pick officers who handle everyday business operations, according to Baker. S corporations often contain both directors and officers.
Shareholder structure, subsidiary restrictions and stock
S corporations are restricted to 100 shareholders, whereas LLCs are allowed an unlimited number of members. Furthermore, an LLC permits non-U.S. citizens to be members whereas S companies do not allow them to be stockholders.
Additionally, there are various subsidiary limits for S corps and LLCs: LLCs are permitted to form subsidiaries without restriction, but S corps are not permitted to do so.
Last but not least, S corporations can issue stock but only one class of stock, whereas LLCs cannot.
Is an LLC or an S corp better for entrepreneurs?
It really depends. A smart starting point is to file to become an LLC since this structure provides liability protection and tax write-offs. However, transitioning to a S corp may make financial sense when your organization expands past the initial phase. According to Vincenzo Villamena, CPA and managing partner of Global Expat Advisors, as LLC revenue rises, so does the self-employment tax.
According to Villamena, “With an LLC, the income goes through to the proprietor, who must pay self-employment tax at a rate of 15.3%. “If the owner lives elsewhere, the Income tax can be reduced by using the Foreign Earned Income Exclusion, however self-employment tax is not. On the other side, with a S company, the owner can use the Foreign Earned Income Exclusion to reduce income tax and collect a salary from the earnings.
According to Anthony Viola, CPA and senior partner at Marks Paneth LLP, S corps may make more financial sense for many firms, but unless there is a compelling purpose to make the transfer, it may not be the wisest decision for a single-member LLC.
According to Viola, “I personally prefer the freedom that LLCs provide business owners.” Yes, paying self-employment taxes has its drawbacks, but with a S corp, owners are obligated to take salaries in accordance with the IRS’s requirements on appropriate compensation.
Are certain types of businesses better suited for LLCs or S corps?
In all sectors, partnerships and sole proprietorships could do best to continue as LLCs. That’s because LLCs are so straightforward that having a corporate status can unnecessarily make things more difficult.
If you don’t intend to sell shares or look for venture capital or angel investor investment as your company expands, an LLC may still be the best option. If not, a S corp could be preferable, as it frequently is for any big, sophisticated corporation.
Can you switch between an LLC and an S corp?
You may change between an LLC and a S corporation, yes. Your company may actually be both at once; the two are not incompatible.
Your state-level LLC status is not in any way affected by applying for S corp status at the federal level. After choosing to submit your taxes under this category, you can even remove your S corp status. Make judgements you’re not likely to change your mind, as this demands additional documentation.
What certificates are required for an LLC and an S corp?
Understanding C companies can help you comprehend LLCs and S corps. C corporations are distinct taxable entities that submit Form 1120 and are taxed under Subchapter C. If the company complies with all Subchapter S requirements, you can convert an LLC or a C corp into a S corp by submitting Form 2553 to the IRS.
According to Brian Cairns, CEO of ProStrategix Consulting, LLCs need business owners to file with the state where the LLC was founded, and these procedures may differ by state.
According to Cairns, “most states need some public notification, which might be expensive depending on the jurisdiction.” For instance, in the state of New York, you are required to advertise in the county where the LLC is founded. This may cost more than $1,000 if you live in one of New York City’s five boroughs.
You must submit articles of incorporation in the state where you wish to incorporate for S corporations. Additional state reporting is needed, as well as an annual shareholder meeting.
Should I have my LLC taxed as an S corp?
You, the other owners, and the nature of your company will determine the best structure for it, but you should be aware of the advantages and disadvantages of having your LLC taxed as a S corp.
The benefits of taxing your LLC as a S company include:
The business pays your salary and its payroll taxes.
Because you would pay self-employment taxes on the business’s gross revenue, just like with a conventional LLC, this might result in tax savings for you.
Additional earnings are distributed to shareholders as dividends.
Since dividends are taxed at a lower rate than income is, doing this can potentially result in financial savings for you.
The drawbacks of taxing your LLC as a S company include:
There’s a salary cap.
Owner-employees must get fair remuneration, which you must determine.
There are limitations.
One class of stock and 100 shareholders are your only options.
In contrast to a C corp, where shareholders might claim employee health insurance as a tax-free benefit, they cannot do so when they possess more than 2% of the company’s shares.
Once you reach the $60,000 annual threshold, having your LLC taxed as a S corp is a wise choice, according to Scott Royal Smith, founder and CEO of Royal Legal Solutions.
This lowers your overall tax rate and enables you to divide your income between personal and dividend income, according to Smith. The disadvantage is that at that time, you also have to pay for an individual S company tax return. You need to compare how much the CPA will cost you to the tax savings in what you keep from the government.
Smith asserts that this often occurs at the $60,000 yearly threshold. Accepting the funds as personal income and filing Form 1040 on your individual tax return as soon as possible is recommended.
Can an LLC purchase a membership interest in an S corp?
No, in general, but there are exceptions in commerce and finance. Owners of a S corp are referred to as shareholders, while an LLC member’s ownership interest is known as a membership interest.
A shareholder’s stake in a firm is represented by shares or stock. An LLC that desires an ownership stake in a S corp would buy shares, not a membership interest, if the corporation doesn’t print stock certificates and merely keeps track of the shares distributed on paper
The rules of Subchapter S prohibit the acquisition or ownership of S corp shares by an LLC with more than one member. S corp stock might, however, be owned by a single-member LLC that is taxed as a disregarded company, which is unusual.
Starting your LLC vs. S corp journey
To provide some legal protection for their personal assets, many business owners set up their new businesses as LLCs. To take advantage of the financial advantages, it’s a good idea to consult your CPA as your company expands and look at filing as a S corp. You should also decide how many investors, stock classes, and foreign owners your LLC will have in order to comply with state law requirements.