Someone said, “The 3 C’s of life were: CHOICES, CHANCES and CHANGES. One must make a choice to take a chance or one’s life will never change”. We are faced with choice in every thing we do, and making the right choices requires sound knowledge of the various options available to us.
When choosing an operating entity for a company, it is very important that we thoroughly research the options available. Your business can be a sole proprietorship, a partnership with someone else, a single member LLC, a pass-through entity like an S Corporation or it can be a C corporation. What I will layout in this blog today are the characteristics of an Limited Liability Company and an S Corporation; the pros and cons of choosing each entity type; and converting from one entity to another.
What Is an LLC?:
• An LLC is a business structure similar to a sole-proprietorship or a general partnership. According to the IRS, ‘It is designed to provide the limited liability features of a corporation and the tax efficiency and operational flexibility of a partnership’.
• As a pass-through entity, all profits and losses pass through the business to the LLC owners (AKA ‘members’).
• The members themselves report the profits/losses on their federal tax returns but not the LLC. Some states charge the LLC an income tax.
• What differentiates the LLC is the limit of the liability for which a member is responsible. Typically, the member’s investment in the company is that limit.
Pros and Cons of the LLC:
• One of the features that distinguishes the LLC from an S-Corp is its operational ease. There are far fewer forms required for registering and there are fewer start-up costs. Filing taxes is a once-a-year affair on April 15: a single-member LLC files a 1040 and Schedule C like a sole proprietor; partners in an LLC file a 1065 partnership tax return like owners in a traditional partnership.
• There are also fewer restrictions on profit-sharing within an LLC as members distribute profits as they see fit. Members might contribute different proportions of capital. Consequently, it’s up to them to decide who has earned what percentage of the profits or losses. Moreover, LLCs are not required to have formal meetings and keep minutes.
• LLCs are not the perfect entity for all businesses. First, an LLC has a limited life: when a member dies or undergoes bankruptcy, the LLC is dissolved. Typically, you would determine in advance the length of the LLC’s duration when you file it with your state. If your future plans include taking your company public or issuing shares to your employees (essentially prolonging its life), then you would need to convert to a corporate business structure.
• The owner of an LLC is considered to be self-employed and must pay the 15.3% self-employment tax contributions towards Medicare and social security. As such, the entire net income of the LLC is subject to this tax.
• The IRS also limits the ‘characteristics’ of your company. An LLC may only have two of the four characteristics that define corporations: ‘Limited liability to the extent of assets, continuity of life, centralization of management, and free transferability of ownership interests.’ Therefore, if you wish to have more than two of these characteristics, you’ll need to convert to a corporate business structure.
What is an S-Corp?:
• An S-Corp is a corporation that has received the Subchapter S designation from the IRS. A business must first be chartered as a corporation in the state where it’s headquartered then file to be considered an S-Corp.
• According to the IRS, S-Corporations are “considered by law to be a unique entity, separate and apart from those who own it”. This allows for a limit on the financial liability for which an owner (AKA ‘shareholder’) is responsible.
• The S-Corp has the ability to have profits and losses pass through to the shareholder’s personal tax return. Therefore the business is not taxed itself, only the shareholders.
• There is an important caveat: any shareholder who works for the company must pay him or herself “reasonable compensation”. Basically, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as ‘wages.’
Pros and Cons of the S-Corp:
• One of the best features of the S-Corp is the tax savings for you and your business. If you remember, the members of an LLC are subject to employment tax on the entire net income of the business. Conversely, only the wages of the S-Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a ‘distribution’ which is taxed at the same rate as the rest of the shareholder’s income.
• The benefits that shareholder/employees receive can be written off as business expenses.
• An S-Corp also allows the business to have an independent life separate from the shareholders. If a shareholder dies, leaves the company, or sells his or her shares the S-Corp can continue doing business relatively undisturbed. Thus by maintaining the business as a distinct corporate entity, clearer lines are defined between the shareholders and the business that improve the protection of the shareholders.
• These could however come with a price, as a separate structure, S-Corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers and records maintenance.
• There will be a greater number of forms required by the IRS for an S Corp.
Combining the Benefits of an LLC with an S-Corp:
• There is always the possibility of requesting S-Corp status for your LLC. Your tax professional can advise you on the pros and cons.
• A special election has to be made with the IRS to have the LLC taxed as an S-Corp using Form 2553.
• This must be filed before the first two months and fifteen days of the beginning of the tax year in which the election is to take effect. Some late elections are allowed by the IRS under special circumstances.
It is important that you consult a qualified tax professional to walk you through this arduous process and to weigh in on the best choice that needs to be made.
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