Two of the most popular entity structures chosen by entrepreneurs and small business owners are S-corporations (S-corps) and Limited Liability Companies (LLCs). In recent years, these entity structures have become very popular because they combine many of the advantages of sole-proprietorships, partnerships and corporations into one entity structure.
So what exactly are S-corps and LLCs?
The S-corp structure is a regular corporation that has between one and 100 shareholders and passes-through net income or losses to shareholders in accordance with Internal Revenue Code. The LLC structure is a business structure that is a hybrid of a partnership and a corporation. Its owners are shielded from personal liability. All profits and losses pass directly to the owners, without taxation of the entity itself. So far, they seem pretty similar, right?
The answer is yes, they are very similar, with a few significant differences. Before we move on to their differences, let us discuss a few more of their similarities.
Similarities Of Both Entity Structures
One of the greatest advantages that both entity structures offer is limited personal liability for the owners. This means that the owners typically are not personally held liable for any business debts or lawsuits. Each structure also allows owners to report their share of business profits and losses on their personal tax returns. This avoids the potential double taxation incurred by owners in C-corporations.
Advantages of LLCs Over S-Corps
An important benefit offered with an LLC is the flexibility in the ownership and ease of operation of the business. Anyone can be an owner in an LLC, including non-U.S. residents, C-corporations, S-corporations, trusts, other LLCs, and partnerships. In contrast, S-Corp stock can only be owned by individuals who are U.S. citizens or residents. S-corps also are restricted to the number of shareholders they can have. Generally this is not a consideration for most owners, as they are allowed to have up to 100 shareholders. LLCs do not have a limit to the number of owners they can have. LLCs, unlike S-corps, are not required to hold an annual meeting of owners and directors, or to keep meeting minutes.
Another advantage of an LLC over an S-corp is the business structure allows owners to distribute profits in any manner they see fit. For example, you and a partner own an LLC, your partner contributed $40,000 for capital, and you contributed only $10,000; however, you perform 90% of the work. The two of you decide that, in the interest of fairness, you will each share the profits 50/50. As an LLC, you can make that decision. However, with an S-corp, you may only take 20% of the profits, while your partner would take the other 80%.
Advantages of S-Corps Over LLCs
One of the major differences between these two entity structures is that owners of LLCs must pay self-employment tax on business earnings, while S-corp owners do not have this tax liability. With LLCs, the owners must pay 15.3% tax on the first $117,000 of income, plus 2.9% in Medicare taxes on their self-employment income over $117,000. This tax can be paid once a year when the tax return is filed or through quarterly estimated tax payments.
Alternatively, S corp owners only pay self-employment tax on their salary, which amounts to 7.65% on the first $117,000 in salary earned in 2014. After meeting this threshold, only 1.45% of Medicare taxes are withheld. The employer portion mirrors the individual’s Medicare and Social Security withholdings. Distributions from the corporation are not subject to FICA withholding—potentially a large tax savings. S Corp distributions are your share of the company’s profits, and considered the return for your investment in the company. The company’s taxable income flows through to shareholders on form K-1. As an owner, you pay federal and state income taxes on this income at your individual income tax rates.
The downside is that owners who are thinking of forming an S-corp should consider the paperwork that comes with being an employee versus being self-employed. Quarterly payroll returns are required to be filed with the IRS and a state agency, in addition to filing annual paperwork with them. The paperwork and time involved with this process should be considered when determining which entity structure is better for you.
Another advantage of the S-corp versus LLC is that a corporation’s existence is perpetual and unlimited, while an LLC typically has a limited life span. Many states require that an LLC dissolve upon the death or withdrawal of a member. Owner transferability is also less restricted with S-corps, as their stock is freely transferable. Ownership interests in LLCs usually require the approval of the other members.
Bottom Line
There is no clear cut way to determine which entity structure is best for your business. As you can see, there are many factors you should consider before making a decision. Generally, if operational ease and flexibility are important to you, the LLC is a good choice. If you want to save money on employment taxes and you would like for the business to continue beyond the life of the owners (for estate planning purposes), an S-corp is a good choice.
For more information regarding the best entity structure to choose for your small business or any other tax-related issues, please contact Henssler Financial at 770-429-9166 or experts@henssler.com.