S Corp vs. LLC: How Should You Register Your Business?

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One of the first things you must decide as a new small business owner is how you want it to be taxed. A limited liability company, for example, can be taxed as a sole proprietorship, partnership, S corporation or C corporation. LLCs and S corporations have quite a lot in common, and choosing one business structure over another depends on your long-term goals.

Both LLCs and S corporations are pass-through business entities and offer limited liability protection for your new business. Although S corporations are more expensive to set up and operate, they may offer some benefits throughout the tax year in the long run.

What Does Limited Liability Mean?

Make sure you understand the meaning of limited liability, a common trait of LLCs and S corporations. This form of legal protection ensures that you won't lose your personal assets if your company goes out of business. Basically, it limits the extent of an economic loss to the assets invested in a company.

A shareholder in an S corporation or the owner of an LLC is not personally liable for any of the company's debts and losses. The same goes for limited liability partnerships. If, say, you own an LLC and fail to pay off business debts, you don't risk losing your home, your car or other personal belongings.

Sole proprietorships, on the other hand, do not offer this type of legal protection. As a sole proprietor, you're personally responsible for any debts that may arise. Both LLCs and S corporations exist as separate legal entities and hence protect their owners and shareholders from any debts, losses and court rulings against the company.

What Is Pass-Through Taxation?

Another aspect you need to consider before choosing a legal structure for your small business is pass-through taxation. Both S corporations and limited liability companies are pass-through tax entities, meaning that they don't pay taxes on their profits at the corporate level. To put it simply, they report their earnings on the owners' individual income tax returns.

C corporations pay tax twice — first at the corporate level and then at the shareholder level. This is the last thing you want if you run a small business. LLCs, partnerships, sole proprietorships and S corporations all face only one layer of taxation.

In fact, it's not uncommon for large organizations to be structured as pass-throughs. In 2016, nearly half of pass-through income was earned by individuals with an adjusted gross income of $500,000 or more. Any business big or small wants to cut costs and maximize profits. Registering an LLC or an S corporation allows you to avoid double taxation and invest more money in your products or services.

What Is an LLC?

According to a 2015 report by the National Small Business Association, about 23% of businesses in the U.S. are LLCs, while 42% are structured as S corporations. Each type of business entity has advantages and drawbacks. Choosing one depends on your operations, finances, legal regulations and long-term objectives.

Unlike sole proprietorships, a limited liability company is a business entity on its own. It's separate from its owner(s) and can open a bank account, get a tax ID number and conduct its day-to-day operations all under its own name. This type of business can have one or more owners who are referred to as LLC members. It combines the flexibility of a partnership with the limited liability of a corporation, offering the best of both worlds.

However, LLCs are not recognized as business entities by the IRS. For this reason, entrepreneurs need to decide whether they want to be taxed as a corporation or a sole proprietorship. The latter option is more suitable for single-member LLCs and requires reporting your earnings on Schedule C of your 1040. An LLC that is taxed as a sole proprietorship still offers limited liability protection.

If you register an LLC and choose to be taxed as an S corporation, you must report your earnings on your personal income tax return. Forming a limited liability company requires registering your business with the state and filing articles of organization. There are no limits on the number of members and no strict management rules, such as the legal obligation to have a board of directors or hold regular meetings, as is required with corporations.

What Is an S Corporation?

An S corporation, also known as an S corp, can have no more than one class of stock and 100 shareholders. Its income and losses are passed through to stakeholders and reported on their personal tax returns. All of its shareholders must be U.S. citizens or permanent residents and may include individuals, estates or certain trusts. Partnerships, foreign investors and other corporations cannot buy shares from an S corp.

This type of legal entity is not considered a business structure. It only indicates its tax treatment IRS. Single-member LLCs cannot choose to pay business tax as an S corporation. This option is only available to multimember LLCs. Also, note that certain businesses, such as insurance companies, may not register as an S corp.

Neither LLCs nor S corporations have to pay tax at the corporate level. In general, LLCs opt to be taxed as an S corp as they grow and earn higher profits. Forming and registering an S corporation, however, is more complex than starting an LLC. If you choose this option, you will need to file articles of incorporation with the secretary of state and complete Form 2553 with the IRS.

Furthermore, S corporations are subject to specific requirements that don't apply to LLCs. For example, business owners must form a board of directors, hold regular meetings, create bylaws and keep detailed records of every meeting, transaction and operation. Additionally, this legal entity requires more bookkeeping and accounting. Be prepared to hire a lawyer and work closely with an accounting agency or hire in-house accountants.

Why Form an LLC?

Starting and running an LLC seems a lot easier than forming an S corporation, but there are some aspects you should take into account before making a decision. With an LLC, it is not required to file tax returns, which is a major advantage. Plus, the cost of registration is next to nothing compared to that of forming a corporation.

Perhaps the greatest advantage of registering an LLC is that it has fewer requirements regarding accounting, bookkeeping and other legal aspects than an S corp. This allows you to save money and may give you peace of mind. LLCs are classified as pass-through businesses. In this case, the company's net income is divided among its members according to the operating agreement.

An LLC cannot issue shares, but it may assign membership units or percentage ownership interests to its members. Their income and voting rights depend on these factors. If an LLC with three owners with equal membership units has a net business income of $90,000 in a given year, each member will receive $30,000 and report these earnings on his annual income tax returns. Additionally, this type of business may be owned by any type of corporate entity and can have an unlimited number of members, both U.S. and foreign citizens.

Also, it's important to note that LLCs may issue bonds just like a corporation can issue shares. This allows its owners to raise capital, which can be used to grow the business, hire more employees, purchase new equipment and so on. Another advantage of registering an LLC is that its structure is significantly less complex than that of a corporation. Anyone can become a member by forming a limited liability company or after he is included in the company's articles of organization.

Are There Any Drawbacks?

As you would expect, this business structure isn't perfect. If your LLC is taxed as a sole proprietorship, you need to pay self-employment tax on all company profits in addition to personal income tax. This may or may not work in your favor depending on how much you earn in a given year.

If your LLC is taxed as an S corp, you will pay personal income tax and self-employment tax on the salary you pay yourself in a given year (LLC owners are classified as self-employed). In this case, you may end up paying less than you would if your company was taxed as a sole proprietorship. However, shareholders in an S corporation are not considered self-employed and don't have to pay self-employment tax.

Transfer of ownership in an LLC is subject to more stringent rules compared to an S corp. If, say, a member decides to leave the company and you wish to replace her, you cannot do so unless the other members approve your request. The shares in an S corp can be freely transferred with no prior approval required.

Advantages of an S Corp

By now, you should have a better idea of how LLCs compare to S corporations. While it's true that S corporations are highly regulated, they offer various tax benefits.

First of all, you don't have to pay self-employment taxes because the company's owners are classified as employees. Second, stakeholders receive profits based on the percentage of shares they own. With an LLC, ownership interest matters less from this perspective. Third, an S corp may distribute any remaining profits to its owners in the form of dividends in addition to their annual salaries, and generally, dividend tax rates are significantly lower than income tax rates.

Another advantage of S corporations is that there are no restrictions on ownership transfer. Stakeholders are free to sell their shares anytime. Additionally, corporations may sell stock to attract new investors and raise capital. This business structure also seems to be more permanent than the structure of an LLC, which can make it easier to get a loan or find investors.

Potential Drawbacks of S Corporations

Forming an S corporation is a lot more expensive and complicated than starting an LLC. The cost of incorporation alone is a turnoff for many entrepreneurs. Expect to pay anywhere between $100 and $250 when filing the articles of incorporation depending on the state in which you operate. You will also need to pay around $50 to $200 in government filing fees plus legal fees, annual filing fees and a franchise tax of $800 to $1,000 (if applicable in your state).

Another downside of S corporations is that they are subject to more stringent rules. This type of business can only have one class of stock and 100 or fewer shareholders. Furthermore, it cannot have foreign stakeholders, which may affect its ability to raise capital. The shareholders in an S corp are required to pay themselves a reasonable salary, and failure to do so may lead to extra scrutiny from the IRS.

The shares of stakeholders in an S corp can be sold in court proceedings, which isn't the case with the membership units assigned by LLCs. Additionally, mistakes regarding filing requirements, stock ownership, reporting and other regulations may result in hefty fines and termination of the company. Shareholders are legally required to hold annual meetings and formal management meetings, which may pose further challenges.

At the end of the day, choosing between an LLC and an S corporation comes down to your business needs. In general, S corporations are a suitable option for service-based businesses and companies with relatively low startup costs. An LLC, on the other hand, gives you more flexibility and has fewer requirements. If you're not sure what to do, you can always start with an LLC and choose to be taxed as an S corporation as your business gains traction.