When you start a small business, the most popular organizational forms are the limited liability company (LLC) and the S corporation. There are advantages to both, and you can even combine their features. Here’s what to consider:
Both LLCs and S-Corps allow income to “pass through” to the owners. Both also provide the owner with limited liability protection. However there are also several differences.
The LLC is structured to provide limited liability features of a corporation along with the tax efficiencies and operation flexibility of a sole proprietorship or general partnership. And like a proprietorship or partnership, each owner (called a member) reports the profits or losses on his or her federal income tax return. The liability protection an LLC offers is typically limited to his or her investment in the LLC.
An LLC has more ease of operation and administration than an S corporation, and also has fewer restrictions when distributing earnings through profit-sharing.
S-corporations pass corporate income and losses, deductions and credits through its owners (called shareholders), who report the income and losses on their personal tax returns and are taxed at their individual income tax rates. S corporations cannot have more than 100 shareholders, and the shareholders may only be individuals, certain trusts and estates. Shareholders cannot be partnerships, corporations or non-resident aliens. One of the big benefits of forming an S-corporation is it minimizes overall tax liability for you and your business. Only wages paid to owners/employees are earned income subject to FICA tax for Social Security and Medicare. Other net earnings pass through to the owners are considered passive income and not subject to SECA tax. The S corporation has a more complex administrative operation and recordkeeping, such as formal minutes, bylaws, forms and filings. Profit sharing also has more restrictions, limiting earning to a proportional percentage of capital contributions by shareholders.
Combining the Two Options
You can establish your business as an LLC but elect to treat it as an S corporation for tax purposes. This requires a special election with the IRS, using Form 2553. Although your enterprise will be an LLC, you will receive the tax benefits of the S corporation but retain the easier administration found in the LLC. You’ll also be better able to minimize overall tax liability.
Obviously, you’ll want to consider all the legal, tax and operational implications that each organizational form may have on your business. The decision you make today can impact your business for a long time, so consult your financial and tax professional about these three options before setting up your business structure.