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What Business Organization is Right for You? - Compare an LLC with S-Corp

By Edited Jul 21, 2015 0 0

Which organizational structure to use to create your business is often a complicated decision with many people having opinions of what they would consider best.  Creating a corporation or an LLC each provide liability protection and the added advantage of creating a separate ‘legal entity”.  We will discuss and explain the corporate business structures and the Limited Liability business structure, then compare the advantages and disadvantages of each type..

For tax purposes, corporations fall under two general categories named according to the subchapter of the I.R.S. that describes them: Subchapter C and subchapter S corporations.

Unless otherwise designated, the I.R.S. assumes all corporations are Subchapter C corporations, which means they are subject to federal corporate income taxes. The problem is that C corporations are susceptible to a “double taxation” scenario because both the corporation and the shareholders (a.k.a. business owners) are forced to pay taxes as the business’ profits change hands from the corporation to the business owner(s).

S corporations, on the other hand, are exempt from federal corporate income taxes. Instead, the company’s profits (or losses) are taxed directly on the shareholders’ personal returns. S corporations are especially attractive to small business owners because they circumvent the possibility of double taxation and offer the best of both worlds: The protection of a corporate structure along with the tax advantages of a sole proprietorship or partnership.  Capital gains are not treated as passive pass-through earnings, as of the 2007 tax year.  Which means these gains can be included in the active pass-through earnings and not in a separate category.

 S corporations do have some disadvantages. For example, unlike other corporations, S corporations are prohibited from retaining earnings in the business since all of the company’s profits are passed through to the owner(s). Also, S corporations may limit the fringe benefits that can be offered to employees.  For everyone that owns 2-percent or more of the stock, the corporation may not be able to deduct the expenses of insurance benefits or these benefits would be added as normal income to the W-2 the recipients.  There have been some organizations that appealed and questioned this policy by the IRS and received a statement allowing the deduction of the insurance benefit expenses if all the non-stockholder employees were offered the same benefits.

To qualify as an S corporation, your business must meet the following criteria:

  • It must be a U.S. corporation and have no more than 100 shareholders.
  • All shareholders must be U.S. citizens or legal aliens living in the U.S.
  • It must issue only one class of stock (e.g. common stock).
  • The corporation is prohibited from owning more than 80% of another corporation.
  • All shareholders must agree to the S corporation designation in writing as part of the application process.

 See Pub 542 of the IRS publications, or visit the IRS website.

 To apply for an S corporation designation, you will need to complete and file I.R.S. form 2553 – Election by Small Business Corporation. There is a time window for filing the form of 45 days from the inception of the corporation for the current tax year, or within 45 days of the new tax year to change the status for the new tax year.  You will also need to collect the signatures of the relevant corporate officers and the shareholders of the corporation.

Your application will be invalid unless it is signed by every shareholder. If you are just starting your corporation, you’ll want to collect the signatures of the corporation’s potential stockholders,  even if some of them never actually fill this role.

 To contrast the S-corporation, the C-corporation and the Limited Liability Company business structures you could use the following grid:

 

Type

PROS

CONS

"S" Corporation

No double taxation.  – The company acts as a pass-through vehicle for the profits to pass to the owners.

Shareholders have personal limited liability.

Profit from S-corp NOT subject to self-employment tax.

By incorporating, raising additional capital, adding or subtracting owners are much easier.

S Corporation may not have more than 100 shareholders.

Shareholders owning 2 percent or more in stock could have limited employee benefits.

More government reporting requirements than an LLC

"C" Corporation

Shareholders have limited personal liability.

Health insurance premiums and group life insurance up to $50,000 in benefits are fully deductible by the corporation and not taxable to the employees.

The corporate tax rate doesn't go as high as the individual rate (what a sole proprietor or partner would pay on an individual tax return).

Double taxation-the corporation pays taxes on its income and the shareholder pays taxes on dividends.

Shareholders cannot deduct the losses of the corporation.

More government reporting requirements than an LLC

Limited Liability Company

No double taxation.  – The company acts as a pass-through vehicle for the profits to pass to the owners personal tax returns.

May have more than 100 members.

Fewer government reporting regulations than Corporation

.

A Limited liability companies are a relatively new business form and the laws are still evolving.

There could be personal limited liability of members.  Some states have decreased or eliminated the limited liability wall shielding the members from personal liability.

Because of less governmental oversight, there is more of a chance of arrangements not completely understood by members

 

 In summary, the creation of a Sub-chapter S corporation usually has more benefits over creating an LLC.  Both provide some shield of limited liability for the owners, but some courts have questioned the limited liability wall of an LLC.  Both an LLC and a Chapter S Corporation act as ‘pass-through’ business structures where the profit of the business ‘passes’ through to the owners personal tax returns and the profit is then taxed at the individuals personal tax rate rather than the corporate tax rate.  The main benefit of the sub-chapter S Corporation over an LLC is that the profit, even though passed-through to the individual from the corporation is not subject to self-employment tax.  Self-employment tax is currently over 15%.  

 It is also true that a corporation has more governmental reporting requirements than an LLC, but in Missouri this is really only an annual report of the current owners and officers that can submitted and paid for online.  Currently the cost for submitting this report online in the State of Missouri is $25.  An LLC does not have this reporting requirement and can save the $25.

A corporation also has the advantage of having the ability to add or subtract owners relatively easily and quickly.  As capital is needed, more shares could be sold.  This is not always possible with an LLC.

In summary, I would usually suggest an S-Corp in most instances and in most states, but check with your local CPA for more specific advice.

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