When starting your own business, at some point in the beginning stages, you will need to decide how to formally structure your business. There are four basic business entities or structures: (1) corporations; (2) limited liability corporations (LLC); (3) partnerships; and (4) sole proprietorships. Which is right for you? Corporations and LLCs offer owners ("shareholders" in a corporation and "members" in a LLC) a shelter from personal liability for the actions of the business. Sole proprietorships and partnerships do not.
A common question asked by those considering a LLC is whether they should form an s-corp instead of a LLC. This question, however, misses the mark because an s-corp is not a separate business structure. An s-corp is just a type of corporation. This article briefly explains the difference and relationship between LLCs and s-corps, and why, in most cases, it is best to form a LLC. LLCs can still take advantage of the tax benefits enjoyed by s-corps without the added paperwork and formality of forming a corporation.
Structurally, Form Your Own Limited Liability CompanyLLCs are preferable to incorporation (includes s-corps and c-corps) because LLCs give the owners of the business much more flexibility and less restriction in the operation of their business.
- S-corps owners (shareholders) must be US citizens or residents; there are no residency restrictions on LLC ownership.
- Both types of corporations ("c" and "s") are subject to rigorous formalities and record keeping that LLCs are not subject to.
- Directors or officers run corporations. Owners can run a LLC, or they can have a manager (non-owner) run it; thus, an LLC enjoys flexibility.
- An s-corp must distribute profits in proportion to shareholder ownership; an LLC can distribute the profits as the owners see fit.
- If, however, a new business plans to go public, it cannot do so as a LLC. The business would have to restructure as corporation (either “s” or “c”).
Basic LLC vs. S-Corp Tax Structure?
There is no tax category for LLCs. So, one-member LLCs are taxed as sole proprietors, multiple member LLCs are taxed as partnerships; therefore, under the above scheme, members of LLCs are considered self-employed and the net income of the business is all subject to self-employment tax (takes money, ~15%, for social security and Medicare).
If, however, the LLC decides to be taxed as an s-corp, the members of the LLC pay themselves a reasonable salary and only their salary is subject to the self-employment tax. The remaining income is distributed among the members as profit, and while still taxed, it is not subject to the self-employment tax.
LLCs only benefit from being taxed as an s-corp if they are making substantial profits because the LLC has to deal with payroll taxes, additional tax-related paperwork, and periodic payments throughout the year. This can drain substantial amounts of resources: time and money, especially for small businesses.