LLC or S Corp: Which Legal Entity Should You Choose for Your Business?
How you structure your business, or the type of legal entity you choose for your company, has implications that go far beyond taxes. It can impact how your business operates and grows, how it is financed, and the level of exposure to liability. This is why the LFL Veritas approach is always to consider business goals and family concerns first, and tax implications later.
There are several factors to consider when choosing between becoming a limited liability company (LLC) and an S corporation (S corp). An LLC is typically easier to form under state laws with fewer state filings and forms. Any person can be an owner of an LLC, and there is more flexibility with regards to how the business operates and how income is allocated among owners compared to an S corp.
There are more restrictions with an S corp. An S corp is limited to certain types of owners, and income can only be allocated in proportion to ownership. In other words, you can’t get creative when splitting income like you can with an LLC. However, an S corp offers more flexibility with regards to how owners are compensated (earned salaries and wages vs. distributions).
Now, let’s take a look at the tax implications.
Social Security and Medicare Taxes
Both LLCs and S corps are pass-through entities. That means neither one is taxed at the entity level so owners avoid double taxation as a corporation and an individual, which happens with C corporations. In other words, income taxes are paid at the owner level, not the corporate level.
With an LLC, all income reported by the owners is typically subject to Social Security and Medicare taxes. With an S corp, the only income subject to those taxes is the salaries drawn. This assumes the company is an operating business, unlike real estate investment, for example.
If an LLC makes $500,000, all of that income is subject to Social Security and Medicare taxes. If an S corp makes $500,000 and the owners take salaries totaling $300,000, only that $300,000 is subject to Social Security and Medicare taxes.
The Single-Member LLC
An LLC with one owner is treated as a sole proprietor for tax purposes. Instead of filing a separate tax return for your business, you file a Schedule C (form 1040) on your personal tax return. Generally, we recommend against this if your company is generating significant income. For example, a corporate entity making $1 million is considered a small business. If you file a Schedule C for $1 million, you could raise some eyebrows at the IRS.
Form as an LLC, but Elect to be Taxed as an S Corp
As an LLC, you have the flexibility to be taxed in a number of different ways, depending on how you want your business to function. An S corp has very limited options. For example, you can legally form your business as an LLC but make the election to be taxed as an S corp. This is as easy as filing an election document.
If your LLC is an active business and the owner’s payroll taxes are high, an S corp election may be beneficial. You still get the benefits of the LLC in terms of reduced complexity, but you have the flexibility to distribute company income as either salaries or distributions.
The Wild Card
Just in case you missed it, we have a new president. He has promised major changes to corporate and individual tax codes and policies. As we all know, campaign promises don’t always translate into actual policy, and any change in policy tends to happen at a snail’s pace.
That said, it’s important to pay attention to the legislation being bantered about in Washington. At some point, it could affect your decisions about how you run your business. Even if nothing changes, which is a distinct possibility, it’s important to meet with your accountant to fully understand the implications of the legal entity you choose for your company.