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

The limited liability company (LLC) is a legal entity separate and distinct from the personal affairs and other business involvements of its owners (called “members”). A LLC has some characteristics similar to those of a limited partnership, some corporation-like characteristics, and still other characteristics unique to the LLC form of business organization.

In some states, limited liability companies have been authorized for several decades. Nebraska’s LLC authorization was first enacted in 1993 and amended in 1994 to authorize formation of family farm limited liability companies. Further changes in the authorizing statutes were enacted in 1997 in LB 44 and LB 361. With the LB 361 modifications, the formation of a LLC has been simplified, LLC taxation has been made consistent with the IRS regulations released in late 1996, and the legal standing of a LLC in Nebraska was made comparable to that of LLCs in other states. Under LB 44, the Secretary of State upon request is authorized to reserve and protect a business name for a limited liability company.

One or more persons may organize a LLC by preparing and filing duplicate copies of articles of organization with the Nebraska Secretary of State. The articles must provide a comprehensive description of the LLC’s name, the purpose for which it is organized, its principal place of business and registered agent, the cash and property to be invested in it, rights and requirements for admitting additional members, and the identity and addresses of managers. The articles also may identify (a) the LLC’s life span unless a shorter period is specified, the life span is perpetual; and (b) any other provisions not inconsistent with the statutes and desired by the members. Upon issuance of a certificate of organization by the Secretary of State, the LLC can commence business activities unless a delayed effective date is specified in the articles of organization.

A LLC may be dissolved when: (a) a life span specified in the articles of organization expires, (b) the members unanimously agree in writing that it should be dissolved, (c) any other dissolution cause specified in the articles of organization becomes a reality, or (d) a court rules that the LLC should be dissolved. Operating procedures for the LLC are set forth in its articles of organization, or in its regulations (similar to the bylaws of a corporation), or in its operating agreement (similar to a partnership agreement). LLC management can be vested in a member or members, or in a manager or managing entity with no ownership interest. With the exception of liabilities for unpaid taxes, members and managers of a LLC are not liable for LLC debt, liabilities, or other obligation including a judgment or decree. Thus, they are protected from general liability though their investments in the LLC, if any, are at risk. This limitation of liability can be nullified if members give personal guarantees for the LLC.

An ownership interest in a LLC is part of a member’s personal estate and can be transferred or assigned according to procedures specified in the articles of organization or in the operating agreement. If neither the articles of organization nor the operating agreement specifies the procedures for an ownership interest transfer, a transfer to a non-member of the LLC must be approved in writing by members other than the transferor who hold a majority in interest. If written consent by a majority in interest is not forthcoming, but a transfer of ownership interest occurs, the ownership interest can be held by a person who is not a member. When this happens, the recipient of the ownership interest has no right to participate in management, but does have the right to share in profits or other compensation and in the return of capital.

As a separate legal entity, LLC finances and records are established and maintained independently of the members’ personal financial arrangements and other business involvements. As is typical of similar legal entities, this separation of finances and records makes it easier to prepare reliable financial analyses of the business unit.

If you are considering organizing a LLC that will own and operate part or all of your business activities, you should secure both legal and tax advice specific to your circumstances, the outcomes you want to attain, and the actions you are considering. Do not make decisions without receiving skilled professional advice.

Potential Advantages of a LLC:

The LLC provides its owners (the members) with a very flexible and adaptable form of business organization that provides liability protection comparable to the protection provided by incorporation of a business unit. Unless personal guarantees have been given, a member’s liability is limited to the amount invested in the LLC, though as indicated above, the manager(s) and/or member(s) have full liability for unpaid taxes.

A LLC can be established at moderate cost in a relatively short time. Management by all members, by one or more members, or by a non-member individual or business entity is allowed. (The management arrangements are specified in the articles of organization.) Ownership interests can be transferred using procedures described in the articles of organization or operating agreement, or by consent of a majority in interest. Thus, the members have a high level of flexibility in setting up or modifying business arrangements.

Possible Limitations of a LLC:

While some other states have extensive experience with LLCs, the track record of LLCs in Nebraska is limited. At this time, it appears that limited experience of individuals and professional advisers with the realities of organizing, operating, transferring, dissolving, and defending LLCs may be the most important single concern about this form of business organization. Some lenders have had limited experience with lending to LLCs, and may be reluctant lending commitments. It may be more difficult to correctly anticipate ownership and management issues that arise during LLC operations, and to develop useful outcomes to those issues. However, experience is accumulating rapidly, and Nebraska’s authorizing statutes now are very similar to those in other states with considerably more experience. Thus, it appears that if the LLC form of business organization is suitable for the business activity under consideration, it can be used with confidence by interested persons.

As is the situation with all multi-owner entities, the suitability and viability of a LLC almost certainly will be closely linked to the ability of members to work together without conflict to attain desired outcomes.

Tax Implications – general:

All real and personal property held by a LLC is taxable to the extent set by Nebraska law. Cash wages paid to LLC employees are subject to payroll taxes in the same manner as for employees of any other type of business entity.

Under the simplified regulations released in late 1996, the federal income tax filing status of a LLC is determined by an election made when the income tax return is filed. Unless the LLC elects to be taxed as a corporation, a single-member LLC is taxed as a sole proprietorship and a multiple-member LLC is taxed as a partnership. A LLC owned by a corporation will be taxed as a corporate division. State income tax filing status is the same as federal income tax filing status. When the LLC is taxed as a sole proprietorship or as a partnership, and assets are placed in or withdrawn from the LLC the tax consequences are those typical of the same transactions by a sole proprietorship or a partnership. This characteristic makes placing land and other appreciating assets in a LLC with sole proprietorship or partnership tax status presently appears to be much more feasible than placing such assets in a corporation.

Net operating income or loss and capital gains and losses pass through to members and nonmember owners for taxation purposes. As such these financial flows are subject to state and federal income tax and, where applicable, to self-employment tax.

Distributions of LLC income can be proportional to ownership interests, or in compliance with an alternative pattern established in the articles of organization _ one that’s tailored to the needs and interests of family members. However, if you want to use an alternative pattern of income distributions, be sure to secure tax advice prior to implementing non-proportional distributions. You need to understand all the potential tax consequences before making non-proportional income distributions.

Gift Tax and Estate Tax Implications:

For members of a LLC, all aspects of the gift tax, estate tax, and inheritance tax are the same as those applicable to any individual. Gifting of tangible assets outside the LLC as a means of utilizing the nontaxable gift allowance of up to $10,000 per recipient per year (up to $20,000 for a joint gift by husband and wife) can be very difficult as assets with the correct value may be not readily available. Gifting may be feasible only if the prospective donor has financial ability to make such gifts without reducing involvement in the LLC and without disrupting non-LLC business and personal life activities.

Gifting fractional ownership interests in annual amounts less than the tax-free limits can be advantageous when such transfers are authorized in the articles of organization or when written approval is provided by members with a majority in interest. The gift of an ownership interest is noted in the LLCs ownership account to complete the gift. If desired, it is possible over time to transfer part or all of the ownership interest from the older generation to members of the younger generation while retaining management control.

Estate planning can provide a plan for minimizing the legal and tax costs of orderly transfer of business and personal assets to successors. If you are considering gifting or other LLC ownership interest transfers to certain to secure and follow the recommendations of your legal and tax advisers when planning and implementing the gift or transfer.

Source:
Nebraska Cooperative Extension NF 96-257
by Paul H. Gessaman, Extension Economist