Updated August 2019.
Of the many business entities that owners consider, Limited Liability Companies (LLCs) and Subchapter S Corporations (S-Corps) are two of the most popular. Although they share the distinction of being ‘pass-through’ entities in addition to providing liability protection, they do have several differences. An owner must also consider operational ease, administrative requirements, profit-sharing, and employment tax implications.
Before choosing one or both of these options, determine which features are most important to you and your company. The needs of every business are different, so it’s worth an hour or two with a knowledgeable attorney to investigate all of the issues that will affect you.
What Is an LLC?
An LLC has a default business structure similar to a sole-proprietorship or a partnership. According to the IRS, ‘It is designed to provide the limited liability features of a corporation and the tax efficiencies 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’). Similar to partnerships, the members themselves report the profits/losses on their federal tax returns.
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. Conversely, a sole proprietor or the partners in a general partnership are each liable for all of the debts of the company. Keep in mind that neither LLCs nor S-Corps necessarily shields owners from their or their employees’ tort actions, such as accidents. Be sure to consult with a good business attorney.
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. Moreover, LLCs are not required to have formal meetings and keep annual minutes.
Some states do charge the LLC an income tax. California not only charges an $800 annual tax, but also a gross receipts fee ranging from $900 to $11,790 depending on the level of annual business receipts attributable to California. This fee starts off once receipts hit $250,000 and reach the maximum fee of $11,790 once receipts hit the $5 million mark.
There are also fewer restrictions on profit-sharing within an LLC as members distribute profits as they see fit. Members might contribute to different proportions of capital and sweat-equity. Consequently, it’s up to them to decide who has earned what percentage of the profits or losses.
But 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 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.
Second, 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. It costs money to have some operational ease!
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. Nevertheless, liability protection isn’t perfect. The plaintiff may be able to ‘pierce the corporate veil’ and go after your personal assets in a lawsuit.
What differentiates the S-Corp from a traditional corporation (C-Corp) is the ability to have profits and losses pass through to the shareholder’s personal tax return. Consequently, 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.’ We’ll see the tax implications of this below.
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. Recall that 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 not subject to employment taxes.
As mentioned above, the shareholder must receive reasonable compensation. If you try to pay yourself an extremely low salary and high distributions, you might get a tax advantage for the year, but the IRS may flag you for audit.
Keep in mind that some benefits that shareholder/employees receive can be written off as business expenses. A member of an LLC can write off business expenses personally against his or her allocable share of LLC income. An S corporate shareholder would be limited by 2% of AGI as well as being subject to Alternative Minimum Tax (AMT), negating any benefits to unreimbursed business expenses paid personally.
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. 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.
The tax savings and solidity of the S-Corp also 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.
In addition to all of this paperwork are the tax forms required by the IRS. Such forms include:
- Form 1120S: Income Tax Return for S Corporation (state tax return)
- Form 1120S Schedule K-1: Shareholder’s Share of Income, Credit, Deductions
- Form 4562 Depreciation
- Employment Tax Forms (941, 940, W-2 and state forms)
- Form 1040: Individual Income Tax Return
- Schedule E: Supplemental Income and Loss
- Schedule SE: Self-Employment Tax
- Form 1040-ES: Estimated Tax for Individuals
- Forms 2553 S Election
These forms are due at various times during the year, so the burden to file them increases.
Also, states do not treat S-Corps equally. Most recognize them similarly to the federal government and tax the shareholders accordingly. In California, S corporations are taxed at the higher of $800 or 1.5% of net income (C corporations are taxed at the higher of $800 or 8.84% of net income). The big difference between an LLC and a corporation is that this tax is based on net income vs. gross receipts as it is in an LLC. An example of this is a business that has $3MM of gross receipts but only $150,000 of net income. An LLC would pay the $800 plus the gross receipts fee of $6,000 for a total of $6,800. An S corporation would pay just the net income tax based upon 1.5% or $2,250. In a second example, let’s assume the business has the same $3MM of gross receipts with $1.25MM net income. An LLC would pay exactly the same amount ($6,800), but the S corporation would pay 1.5% of the net income, or $18,750.
Combining the Benefits of an LLC with an S-Corp
There is always the possibility of requesting S-Corp status for your LLC. Your attorney will advise you on the pros and cons. You’ll have to make a special election with the IRS to have the LLC taxed as an S-Corp using Form 2553. And you must file it before the first two months and fifteen days of the beginning of the tax year in which the election is to take effect.
The LLC remains a limited liability company from a legal standpoint, but for tax purposes, it’s treated as an S-Corp.
A Final Note
With the Trump Tax Reform Act taking effect January 1, 2018, a new section of the tax code was created, Code Section 199A. This code states that there is a 20% deduction off of income for federal tax purposes. However, there are limitations on the deduction regarding the amount of W-2 compensation. This should be heavily considered when deciding your business’ entity type as the 20% deduction is around until the end of 2025.
Hall & Company is a leading California accounting firm comprised of tax experts and business consultants. Our Orange County CPA team is well-versed in the latest tax code developments, and we’re ready to help you navigate through any critical business financial decisions you may face. Contact us today to speak with an experienced tax or audit professional. For more information regarding general finance topics, visit our blog. Or, for real-time updates about Hall & Company news and events, follow us on Twitter.