Many business owners structure their companies as limited liability companies (LLCs) or S-corporations. On the surface there are several similarities. Both types of entities avoid corporate income tax. Instead, business income is passed out and taxed only once on the tax returns of LLC members or S-corporation shareholders. Moreover, both LLC members and S-corporation shareholders have limited liability; meaning their financial exposure from the company’s operation generally is no greater than the amount invested, plus any notes personally signed and/or guaranteed (In exceptional circumstances, creditors may gain access to additional personal assets of the business owner – via a process know as “piercing the corporate veil”). Nevertheless, there are differences between the two structures, which you should consider when choosing between them.
Looking into LLCs
In some ways, an LLC resembles a sole proprietorship or a partnership, but with the advantages of limited liability. Usually, you can form an LLC with relatively little paperwork, and there may be few tax returns to file once an LLC is operational. In general, LLCs have less burdensome and rigid recordkeeping and reporting requirements than corporations. If an LLC has multiple members, the business has a great deal of flexibility in how profits are distributed among one another.
One potential downside to an LLC is that it may have a limited life. Depending on state law and the operating agreement, the death of a member may result in immediate termination of the LLC, for instance. In addition, taxes can be relatively high for LLC members. That’s because net income of the LLC is frequently passed through to members as earned income on their personal tax returns, pursuant to the LLC agreement. This type of income is generally subject to an additional 15.3% tax, known as “self-employment tax” (which represents the employee and employer shares of Social Security and Medicare), but this potential trap can be avoided with adequate planning.
Even after making an election to be taxed under Subchapter S of the Internal Revenue Code (IRC), an S-corporation is still a corporation. There are meetings that must be held, minutes that must be kept, and extensive paperwork to process. Such efforts can be time consuming and expensive.
In addition, S-corporations must meet certain requirements. A business with more than one class of stock or a shareholder who is not a U.S. citizen or resident can’t be an S-corporation, for example. Similarly, an S-corporation can’t make disproportionate distributions of dividends or losses (unlike an LLC).
On the positive side, S-corporation shareholders can receive a salary, on which they owe payroll taxes (paid 50/50 by the corporation and shareholder). Or, on the other hand, shareholders can receive a dividend for which no payroll taxes are due. While paying shareholder(s) an unreasonably low salary can draw scrutiny from the IRS, S-corporation owners may pay significantly less in annual payroll taxes than LLC members pay on similar company related income (i.e., “self-employment tax” discussed above). What’s more, S-corporations can be long-lived, and this permanent nature may make them more attractive to lenders and investors than potentially short-lived LLCs.
Choosing or Combining
Your choice of business structure may come down to whether you prefer the simplicity and flexibility of an LLC or the potential tax savings and lender/investor appeal of an S-corporation. State laws vary, so a tilt in one direction or another may influence your decision.
Yet another possibility is to set up your business as an LLC and then request S-corporation taxation by filing IRS form 2553, Election by a Small Business Corporation. My office can review your specific circumstances to help you decide the best approach for structuring your company.
–How to Create a Louisiana LLC by Dillon Wright