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

An “S Corporation” is a corporation that elects to be taxed under Subchapter S of the Internal Revenue Code (enacted in 1958 and periodically amended) and receives IRS approval of its request for Subchapter S status. As a legal entity (an artificial person), the S corporation is separate and distinct from the corporation’s owners (the stockholders). Under Nebraska incorporation law, there is no distinction between a C corporation and an S corporation. However, the two type of corporate entities are subject to differing federal and state tax treatment.

Eligibility for S corporation tax status is based on compliance with IRS regulations regarding the number and characteristics of stockholders, type of stock issued, and other characteristics specified in the regulations. Principal characteristics of S corporation taxation are briefly discussed in this document.

An S corporation can issue only one class of stock. Prior to January 1, 1997, an S corporation can have no more than 35 stockholders. In tax years beginning after December 31, 1996, the maximum number of eligible stockholders is increased from 35 to 75. Nonresident aliens, self-directed IRAs, some types of corporations, partnerships, and some types of trustees presently cannot hold stock in an S corporation and will continue to be ineligible after December 31, 1996. However, in tax years beginning after that date, a qualified retirement plan trust or a 501(c)(3) charitable corporation may be S corporation stockholder. Other restrictions on stockholder eligibility apply under some circumstances. Your attorney can determine whether any of these restrictions apply in your situation.

After December 31, 1996 a testamentary trust can hold S corporation stock for up to two years from the date of the grantor’s death. (Prior to January 1, 1997, the holding period is 60 days.) Generally, this change will make it easier to settle an estate where a testamentary trust is established and receives S corporation stock in the estate settlement process. Consult your attorney for advice and guidance on applications of this longer holding period to the administration of any testamentary trust that receives S corporation stock.

As a separate legal entity, the corporation finances and records are established and maintained completely separate and distinct from the finances and records of the stockholders. Through a resolution adopted at a stockholders meeting held in accordance with the bylaws of the corporation, one or more officers or employees of the corporation are authorized to conduct business on behalf of the corporation. The resolution typically includes an authorization with specified limits to borrow and repay funds as needed for business operations. Credit arrangements are made in the name of the corporation with loan documents signed by the authorized person or persons after the lender has received a certified copy of the authorizing resolution. If the corporation is newly formed, small (has few assets), or has a limited record of credit use, it’s likely that a lender will require personal guarantees by one or more officers or stockholders before approving a credit application received from the corporation. If personal guarantees are given, the signer(s) usually have unlimited liability for the debts of the corporation.

The Corporate Charter includes information on the purpose(s) for which the corporation is organized and the life of the corporation. (A corporation often has perpetual life.) Bylaws of the Corporation are the “rules” for conducting the organizational life of the corporation.

Moderate legal costs are incurred in setting up a typical S corporation and annual costs are incurred for stockholders meetings, tax return preparations, and preparing other yearly reports and summaries as needed for management and as desired by stockholders. Public notice of the formation and continued operation of a corporation is required and is accomplished through filings with the Secretary of State’s Office.

Advantages of the S Corporation:

Creation of the corporate shield that, in the absence of personal guarantees, limits the liability of stockholders to their capital investment in the corporation and the usefulness for estate planning purposes of the corporate form of business organization are frequently cited advantages of forming an S corporation. Other advantages include:

• The independent life of the corporation makes possible its continuation, and the relatively undisturbed continued operation of the business regardless of incapacity or death of one or more stockholders.
• Fractional ownership shares are easily accommodated in the initial offering of stock.
• The purchase, sale, and gifting of stock make it possible to have changes in ownership without disturbing the corporation’s ability to conduct business.
• The requirement that the corporation’s finances and records be separate from the finances and records of stockholders reduces the risk of unrecognized equity liquidations.
• With only a few exceptions, under the Subchapter S election for taxation as a partnership the S corporation pays no income taxes and corporation income or loss is passed through direct to the stockholders.
• To the extent the corporate shield is maintained and other investments and savings of the stockholders are not at risk, the personal life of stockholders is simplified.
• The annual meetings of stockholders and consultations with legal counsel can provide stimulus for improved communication within the stockholder group (often a family group) and can provide more comprehensive guidance for management.
• Depending on the corporation’s business record and the policies and practices of prospective lenders, access to credit and the ability to secure needed resources may be improved.
• Earnings representing “return on investment” (interest, rental payments, etc.) are not subject to self-employment tax as long as stockholder-employees receive adequate compensation for labor and management of the business.

Limitations of the S Corporation:

As a corporate entity entitled to taxation as a partnership, some limitations have been placed on who can be a stockholder of an S corporation. Consult your legal adviser regarding the possibility that these restrictions may apply in your situation. (See “Your need for legal and tax advice.”)

Other limitations of the S corporation include:

• Lenders may require personal guarantees from corporate officers as a condition of supplying credit, thus negating the limitation of liability.
• Conflicts or disagreements among the stockholders (usually a small group of persons) may immobilize decision making.
• Restrictions on the sale of stock and/or buy-back agreements included in the bylaws may prevent minority stockholders from being able to recover the value of their investment in the corporation.
• Through the processes of gifting and inheritance, stock ownership can become divided among many persons who are not active in the business and they may become a voting block that does not support needs and decisions believed desirable by managing stockholders.
• Over time, corporation paid benefits for stockholder-employees may become costly and exceed the ability of the business to pay.
• Employment benefits such as life insurance, health insurance, and housing costs are taxable income to stockholder employees with 2 percent or more stock ownership and to employees who are directly related to persons owning 2 percent or more of the corporation stock.
• If appreciated assets are owned by the corporation and the corporation is dissolved, significant income taxes on the appreciation amount will be generated.

The corporate shield of limited liability may be lost:

• When corporate formalities are not followed — that is, when director and shareholder meetings are not held and minutes of such meetings are not kept.
• When corporate assets are treated as personal assets — for example, when a corporate vehicle is used for family vacation and the corporation is not reimbursed for the nonbusiness use.

When limited liability is lost, shareholders become personally liable for any corporate legal or financial obligations. In addition, if corporate income tax returns are audited, failure to observe corporate formalities or treating corporate assets as personal assets can result in loss of corporate income tax deductions and levying of penalties and interest on taxes assessed for previous years.

Tax implications — general:

All real and personal property held by an S corporation is taxable to the extent set by Nebraska law. Corporate income or loss, including capital gains, pass through to the stockholders, and is treated as income to the receiving individuals. In the same manner as partnership income, S corporation income passed through to stockholders is subject to state and federal income tax, but is not subject to self-employment tax when employee-stockholders receive. adequate compensation (salaries) for their labor and management input to the business. Pay of corporation employees (salaries) are subject to payroll taxes in the same manner as is the case for employees in any other type of economic activity.

Assets of the corporation generally are retrieved to individual ownership only through transactions that generate taxable income. Sale of stock establishes the market price as the purchaser’s tax basis for the stock, but does not increase the tax basis of assets of the corporation. Death of a shareholder may result in a “step-up” of the tax basis of his or her corporation stock, but does not increase the tax basis of assets held by the corporation.

If the corporation is dissolved when it owns assets that have appreciated in value (usually land, buildings, and/or equipment), federal income tax will be due on the asset appreciation amount even though the assets have not been sold. For this reason, many management advisers and estate planners recommend holding title to land in an entity separate from the corporation, — for example, in individual ownership or in ownership by a limited liability company. When this is done, the corporation rents the land from the individual or noncorporate entity. Generally, this approach is useful only when the value of fixed assets is relatively large or there is good reason to believe they will experience significant appreciation in value.

Gift tax and estate tax implications:

All aspects of the gift tax, estate tax, and inheritance tax apply to the receipt of corporate stock by gift or inheritance. Tax amounts are calculated on the value of the stock included in the gift or inheritance. Gifting of stock to utilize the nontaxable gift allowance of up to $10,000 per recipient per year (up to $20,000 for joint gifts by husband and wife) can be easily accomplished. Estate planning can provide a plan for minimizing the legal and tax costs of orderly transfer of corporate stock and/or noncorporate business or personal assets to successors. If you are considering gifting or other transfers of stock or other assets, be 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 96-255
by Paul H. Gessaman, Extension Economist