S Corporation vs. LLC: Which is Best for Your Business?
If you are a small business owner thinking of making the switch from a sole proprietorship to a different kind of legal structure, the choice basically comes down to choosing between an LLC (limited liability company) and an S corporation. Which one should you choose?
Both have their advantages, and both have limitations. As I have mentioned before in a prior post, there is no one right entity that all small business owners should use–it is a matter of picking the best one for YOUR business in view of your own particular unique set of facts.
In a nutshell, the choices break down like this: if you want simplicity, ease and flexibility of operation, choose an LLC. If you want to potentially save some significant tax dollars, go with an S corporation. We’ll look first at what limited liability companies have to offer, and then turn to S corporations and their features.
Limited liability companies are hybrid creatures that combine some of the best aspects of a limited partnership and a ‘regular” or “C” corporation. In a regular limited partnership (LP), a limited partner invests capital into the LP and is able to feel secure in the knowledge that he/she only has liability exposure for the amount of the investment. Even if the business goes broke, the limited partner’s personal assets are not at risk.
This is in contrast to the general partner of the limited partnership, who has unlimited liability for the debts of the business–a very undesirable situation. The tradeoff for the limited partner is that they are not able to participate in the operation and running of the business, but must remain mere passive investors.
An investor (stockholder) in a “C” corporation, on the other hand, has both limited liability (they cannot lose more than the amount of their investment) and the ability to participate in the management of the company by electing themselves as an officer of the corporation. The difficulty here lies in the fact that “C” corporations, unlike limited partnerships, are not pass-through entities for purposes of the Internal Revenue Code.
This means that if you make $50,000 in your “C” corporation, the corporation itself must taxes on the earnings (in this case, $7500) and the money left over ($42,500) must then be distributed as a dividend to you the owner, and you must pay personal income taxes upon it a second time at your personal tax rate (ranging from 10% to 33%). This is referred to as double taxation and is generally something that ought to be avoided.
In addition to the burden of double taxation, “C” corporations require profits to be distributed in the ratio that the stock is held. For example, Harry and Todd form a “C” corporation by each contributing $20,000 in cash for 50% of the stock. At the end of the first year, when it comes time to split their profits of $70,000, they are required to split the distribution 50% to Harry and 50% to Todd. If this is what both Harry and Todd want, then there is no problem (other than the double taxation that has occurred).
However, say that Harry is not all that interested in running the business. He does not want to spend any time in it and thinks of his $20,000 as an investment that will provide him with a return when the business is sold in ten years to another company. Todd on the other hand depends on the business to provide his income, and so works in the business 65 hours a week.
Harry and Todd think that it would be fair to divide the total $70,000 in profits $55,000 to Todd and $15,000 to Harry. In a C corporation this is not possible as the law requires them to split the profits in the ratio of their stock ownership by taking $35,000 apiece. However, in a limited partnership no such limitation exists and they can carve out virtually any sort of profit splitting arrangement they want, as long as they both agree to it.
Thus, if we were to combine the best characteristics of both C corporations and limited partnerships we would have an entity that:
1. Has no limitations on how owners can split profits,
2. Does not have double taxation,
3. Has limited liability for its owners, and
4. Is simple to operate.
All of the above describe an LLC perfectly. An LLC is taxed as a partnership so it has no limitations on how owners can split profits, and there is no double taxation to worry about either. However, an LLC also has the good characteristics of a corporation in that it has limited liability protection for all of its owners (unlike a limited partnership which only has liability protection for the limited partners and not the general partners). An LLC is also simple to operate, with less formalities and record keeping required than that of a “C” corporation. If you are a one owner LLC, the ease of operation is even greater (see my previous post on LLCs).
All of the above could lead someone to conclude that the small business owner looking for a business entity solution should end his search with an LLC. If it were not for a special provision in the Internal Revenue code, that would be true.
However, S corporations offer a tremendous opportunity to save taxes that an LLC does not, in the area of FICA/self-employment taxes.
As a sole proprietor, you have the “opportunity” to pay 15.3% of the net earnings of your business to the government in the form of payroll tax (these contributions go to the Social Security and Medicare trust funds). For many business owners, this is the single largest tax they will pay (greater in some cases than their federal and state income taxes combined).
Obviously, many business owners would like to minimize this tax if possible. For someone who operates an LLC, the entire amount of their net income is subject to the tax. Let’s say Harry owns a computer repair shop with three employees. After all business expenses are deducted, his net income is $50,000. If Harry operates his business as an LLC, he will owe $7,650 in self-employment taxes.
Contract this with what happens if he operates his business as an “S” corporation. Instead of being self-employed, Harry is now technically an employee of the corporation that he owns. After looking around his area and surveying what computer repair shop managers are paid, Harry determines that a reasonable salary for the work that he does would be $33,000.
Here is where an S corporation works to Harry’s advantage. Although his total earnings are still $50,000, Harry only needs to pay employment taxes on the $33,000 he paid himself as a salary. The other $17,000 dollars he distributes to himself as a “distribution” from his S corporation. Distributions are not subject to employment taxes under the Internal Revenue code. As a result, his total employment tax is now only $5,049.
His total employment tax savings are $2,601. Put differently, he has cut his employment taxes by 34%!
When I show this to clients, many immediately clamor to incorporate themselves that very day. Before rushing to assume that an S corporation fits your needs better than an LLC, a couple of points should be noted.
Pigs get fat–hogs get slaughtered. When I share this technique with clients, I can see the wheels turn in their mind as they secretly calculate “I can save ALL the employment tax I pay by cutting my salary to zero, and owing no employment tax at all.”
Wrong. The IRS is not staffed by fools. They can and will “recharacterize” your distributions as salary if it is not reasonable. Where the line is that separates reasonable from unreasonable, no one can say exactly, but “reasonable” is certainly not a salary of $5,000 on earnings of $70,000. Don’t be greedy. Note also that S corporations save you money on employment taxes only. They are essentially neutral from an income tax standpoint, which means you will generally pay no more or no less income tax than if you were an LLC.
An S corporation has many of the attractive features of an LLC, in that it is also a pass-through entity with no double taxation, and it also gives limited liability to all of its owners.
There are also disadvantages of an S corporation compared to an LLC. First of all, there are restrictions on who can be an owner of an S corporation. Owners cannot include nonresident aliens or other corporations or LLCs, and you are limited to a maximum of 75 stockholders in an S corporation. Like C corporations, S corporations suffer from a lack of flexibility in how profits can be split up among multiple owners. Finally, if you are going to borrow money for the operation of your business, and you are operating at a loss, you may not be able to deduct as much of your loss if you are operating your business as an S corporation as you would if you were an LLC.
If you are a sole proprietor, none of the above concerns probably matter very much to you.
There is one final concern, however, that matters a great deal to many sole proprietors and that is the paperwork that goes with payroll tax. The IRS is devoid of a sense of humor when it comes to payroll taxes—they must be paid and paid on time or interest and penalties are sure to follow. If you are either an LLC or a sole proprietor without employees you do not need to prepare payroll tax returns and probably have no experience in dealing with them.
You will need to gain this experience if you become an S corporation as you will need to prepare payroll taxes for your own wages. Since you are now an employee of your own corporation, you will need to pay the IRS your withholdings (both federal income tax and FICA) from your salary on at least a quarterly basis. (What this means is that you cannot wait until the end of the year and pay your taxes—you must do it as you go along).
The preparation of these returns is not onerous in terms of time. It is merely a matter of remembering to do them on time and being religious about setting aside the money to pay the taxes.
One final point of note is that if you are looking for an entity in which to hold your rental real estate, an LLC is definitely your choice. Rental income is not subject to employment tax and therefore there are no advantages to holding it in an S corporation.
One of the key points you have hopefully gained in all of this is that choosing between an LLC and an S corporation is an undertaking that is dependent upon a sound knowledge of the tax laws. I strongly recommend that you discuss any choice of entity questions with your CPA or tax attorney to make sure there are no pitfalls awaiting you in your selection process. There are numerous other tax law implications to your choice of entity selection, too numerous to be discussed here, but ones which your tax advisor can help you evaluate properly.
A summary of the reasons to pick each entity are as follows:
S corporation:
Pros:
1. Substantial savings possible on FICA taxes
2. Limited liability protection
3. Pass-through entity with no double taxation
Cons:
1. More paperwork to administer
2. Need to file payroll tax returns on a regular basis
3. In some cases, you are restricted in your ability to take loss deductions if you have borrowed money to run your business
4. Restrictions on number and type of owners
5. If multiple owners, no flexibility on how income can be split up
Limited liability company
Pros:
1. Simple to administer
2. No payroll tax returns to prepare
3. Limited liability
4. Pass-through entity with no double taxation
5. No restrictions on ownership
Cons: No ability to save on FICA taxes