Incorporating a business is important for two primary reasons: (1) to protect personal assets from business creditors; and (2) to obtain favorable tax treatment for all business income. The purpose of this article is to educate small business owners regarding the two types of corporate entities that are particularly preferable for small businesses: the Limited Liability Company (LLC) and the S-Corporation. In deciding between incorporating as an LLC or as an S-Corporation, there are a number of considerations to take into account:
A. Similarities between an S-Corps and LLCs: favorable tax treatment and limited liability
Both S-Corps and LLCs prevent double-taxation (taxation at both the corporate and individual level) and limit the personal liability of shareholders.
1. Prevention of double-taxation
One benefit that LLCs and S-Corporations have over other corporate forms is that they allow all income to pass through the business and flow directly to the business’ principals. This is important because all losses and or earnings are reported on the principals’ tax returns, rather than on the business’ income report. This eliminates the corporate tax, otherwise as the “double tax” of standard corporations.
In the case of standard corporation (or a C-corporation), the net income of the corporation is subject to the corporate tax. The crucial distinction between a C-corporation and an LLC or an S-Corporation is the tax implication on the remaining income after the corporate tax. In the case of a C-corporation, after the corporation has been taxed, all remaining money is taxed a second time when it is distributed as dividends to the shareholders of the corporation. This is not the case for an LLC or an S-Corporation.
2. Protection of personal assets
When a business is properly incorporated as an LLC or as an S-Corporation, it will take the brunt of any potential lawsuit that may occur during the operation of the business, while shielding the owner’s personal assets from the company’s liabilities.
B. Differences between S-Corps and LLCs: distribution of income and employment tax
The most important differences between LLCs and S-Corps involve:
(1) differing rules regarding ownership and distribution of income to shareholders
(2) differing rules for employment tax.
1. Ownership and Distribution of Income
S-Corps are subject to many restrictions that do not apply to LLCs. For example, S-Corps must have 75 or fewer shareholders, all shareholders must be U.S. citizens, and shareholders cannot be LLCs or corporations. However, certain types of entities are not allowed to file as an LLC, and must therefore file as an S-Corp.
Among the restrictions that S-Corps place on their shareholders is a restriction on the way corporate profits are distributed. All S-Corp profits are distributed based on the ratio of stock an owner holds in the corporation. For example:
Al, Ben, and Charlie form ABC, Inc. as an S-Corporation. Al invests $10,000, while Ben and Charlie each invest $5,000. Al would have 50% ownership in the corporation with Ben and Charlie each having 25% ownership in the corporation. When profits are distributed, Al would receive half of all profits distributed, while Ben and Charlie would each receive a quarter of the profits.
LLCs do not have as many restrictions as S-Corps. In the case of an LLC, the wishes of the owners, not the stock-ratio-system, determine how corporate profits are distributed. For example:
Al, Ben, and Charlie form ABC, LLC. Even if Al invests $10,000, while Ben and Charlie each invest $5,000 (as in the previous example), Al, Ben and Charlie could decide to distribute corporate profits according to each shareholder’s ownership percentage. Since ABC, LLC is an LLC and not an S-Corp, Al, Ben, and Charlie would be restricted to the stock-ratio distribution.
2. Employment tax
First, a disclaimer: the tax implications for the various corporate forms are complex. Below is a general description of the way that LLCs and S-Corps are treated differently for employment tax purposes. The employment tax is currently set at 15.3% for both S-Corps and LLCs. However, this tax is applied differently two the two business types.
An S-Corporation’s owner’s salary is the only corporate income that is subject to the employment tax. Conversely, in the case of an LLC, the entire amount realized in the business (profits before subtraction of salary) is subject to the employment tax.
Back to our example:
Let’s say that ABC, Inc.’s total earnings for the year equals $200,000. ABC, Inc. pays each of its owners, Al, Ben, and Charlie, a salary of $50,000 (a total of $150,000 in salary). Since ABC, Inc. is an S-Corp, ABC, Inc.’s remaining profits are not subject to the employment tax and will pass directly, untaxed to its owners. Therefore, the total unemployment tax for the owners of ABC, Inc. will be $22,950 (15% of the $150,000 paid out in salaries).
Now let’s take a look at how this would play out for ABC, LLC. Again, the corporation realizes a $200,000 profit. This entire profit is subject to the employment tax at a rate of 15.3%, before salaries are paid. Al, Ben, and Charlie’s total employment tax would be $30,600 (15.3% of $200,000 total profit).
We can see from this example that Al, Ben, and Charlie can save $7,650 in employment tax by forming an S-Corp rather than an LLC.
C. Which entity is right for your business?
As a general rule, S-Corps are more restrictive than LLCs, but receive more favorable employment tax treatment. In determining which business entity works best for your business, you should make a careful assessment of your particular needs and consult with your attorney and accountant. In making your assessment, you should bear the following features of each entity in mind:
The owners can be paid by the amount of work they do, rather than by the percentage of stock owned.
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