S Corp vs LLC: Which Business Structure Is Right for You?
If you're a small business owner, one of the first choices you make in your business is selecting a business structure. Perhaps you started as a sole proprietorship but are considering a more formal structure. Or maybe you opted to create a limited liability company (LLC) but heard that you can reduce your tax burden by making an election to be taxed like an S Corporation.
It's easy to get stuck trying to figure out which business structure is right for your company. So let's look at two popular options S Corp vs LLC.
This article explores both LLCs and S Corporations in detail to help you make a more informed decision about what's right for you.
S Corporation vs Limited Liability Company: Defining the Difference
Let's start with a high-level overview of the difference between an S Corporation and an LLC.
S Corporation
An S Corporation is a corporation in the eyes of the state in which it was formed, meaning it's a separate legal entity from its owners or shareholders. The business—not the shareholders—is liable for any losses or business debts incurred by the company while operating.
Becoming an S Corp involves making an election with the Internal Revenue Service (IRS) to be taxed as a small business corporation. This means instead of paying corporate income tax, corporate profits and losses "pass through" to the owners or shareholders, who pay taxes on their personal tax returns. This is a tax classification rather than a formal business structure.
IRS rules limit which businesses can opt to be treated as small business corporations to those that:
are domestic corporations
have allowable shareholders (individuals, certain trusts, and estates)
have no more than 100 shareholders
have only one class of stock
are not an ineligible corporation (certain financial institutions, insurance companies, and domestic international sales corporations)
LLC
An LLC is similar to an S Corporation, but it's governed by LLC statutes in its state of formation rather than corporation statutes. Limited liability companies offer limited liability protection for their members, meaning only the business is liable for its debts and liabilities. However, owners remain personally liable for any wrongdoing they commit during the course of the business. An LLC is also a pass-through entity for tax purposes.
The IRS doesn't place the same ownership restrictions on LLCs. They can have an unlimited number of members and allow non-US citizens, corporations, partnerships, and even other LLCs to be members.
LLC vs S Corp: Deciding Which Business Entity is Right for You
Now, let's look at a few considerations when choosing between an LLC or an S Corp for your business. Keep in mind these are tax considerations—there may be other legal considerations that you should discuss with your attorney.
Self-Employment Taxes
S Corporation shareholders may be able to save on self-employment taxes compared to an LLC. S Corp owners are treated like company employees, paid a reasonable salary, and have FICA taxes withheld from their paychecks.
LLCs, on the other hand, don't pay members a salary. So LLC owners pay self-employment tax (the self-employed version of Social Security taxes and Medicare taxes) on 100% of their share of business profits.
Allocation of Profits & Losses
S Corporation shareholders must receive their profits and losses based on their percentage of ownership. In other words, a 50% shareholder receives 50% of company profits.
LLCs can allocate profits and losses on any basis they want. For example, say two business owners start an LLC together. Owner A contributes 40% of the startup capital but doesn't plan to engage in the company's day-to-day operations. Owner B contributes 60% of the startup capital and will completely manage daily business operations. The two owners can agree that Owner B should receive 80% of the profits to accurately reflect their involvement in the business (or 70% or 90%, or any other allocation that makes sense).
Owning Real Estate
Getting properties in and out of an LLC without tax consequences is easy. However, if your business plans to own real estate, you may want to reconsider electing it to be taxed as an S Corporation.
First, contributing appreciated property into an S Corp is a taxable event when the shareholder contributing the property owns less than 80% of the corporation's majority vote after the transfer occurs.
Also, once you put an appreciating asset into an S Corp, you can't take it out without triggering capital gains tax on the built-in appreciation.
To illustrate, say you bought a rental property worth $250,000 five years ago and put it into an S Corp. The property appreciated to $500,000 over the next five years. For tax purposes, you have $250,000 of built-in capital gains. If you want to take the property out of the S Corp for any reason—perhaps to use it as collateral for a personal loan or transfer the property to a family member—you will trigger capital gains tax on the gain. That tax bill could have been avoided if the property were held in an LLC.
Ultimately, it's important to remember that there is no perfect solution when looking into how to structure your business. Every situation and company has its own unique factors, so it requires research and careful consideration to select the best option for you. To help in this decision-making process, contact the experienced team at Slate Accounting. We're happy to answer questions and discuss solutions regarding LLCs, S Corps, and other business structuring options. With our expert knowledge base and personalized approach, we can help you guide your ultimate decision as to which structure will best meet the needs of your business.