Once you have chosen to form a separate entity for your business to protect yourself from liability and make use of the tax advantages, then the only decision left is whether to form an LLC or an S Corp.
This information will show you the primary differences, and then help you decide which form fits your situation better.
First, note that both S-Corps and LLCs offer basically identical protection from personal liability, so from that standpoint either choice is fine. Both require formal registration with a state, and more than one state if you are planning to have business operations in more than one state (meaning an office, a warehouse, or other physical presence conducting business- out of state sales are not counted).
Also, both pass through profits and losses to the owners, unlike a C-Corp, which holds the funds unless specifically disbursed.
These are the main differences:
Self Employment Tax
An S-Corp only pays self employment tax on the salary of shareholders, not on the profits. An LLC pays self employment tax on all the money passed through to owners. This is one of the biggest advantages of S-Corps.
Profit and Loss Division
With an S-Corp, profits and losses must be split exactly according to percentage of ownership. In an LLC, the members can decide themselves who gets what irrespective of the amount they own.
Types of Owners
An S-Corp can only be owned by individuals, and the number is limited to 100. An LLC can have owners that are other corporations or LLCs, and there is no limit on the number.
Documentation
An S-Corp is required to have Bylaws, Minutes, Annual Meetings, and a formal issuance of stock. An LLC requires very few formalities.
Now, looking at the above, how do you decide which makes the most sense?
First, let’s look at the reality of the second two categories- types of owners and documentation. The fact is, very, very few small businesses will ever have to worry about having another corporation own shares, or having more than 100 members.
And, if you do ever reach that point, it is easy enough to convert to an LLC or C-Corp, and more than likely at that point you will be big enough that you will have a regular lawyer anyway who can handle the switch for you.
So this advantage really won’t apply in the real world either way, unless you are starting a business with an investor, and they are going to hold their ownership through their own corporation.
The reality on documentation is that while it is important to keep it up, it really only takes an hour a year to do the required paperwork for an S-Corp if you are a one owner company, and only a little longer than that if you are just a few partners.
If you have out of state investors, or a more complicated financing arrangement, then it will become more time consuming and critical to stay on top of the paperwork. But, again, for the vast majority of businesses, the difference is minimal and not one likely to sway your decision.
The main concern are the first two- self employment tax and profit and loss sharing.
When considering self employment tax, ask yourself if there will be several partners, all working full time on the business and taking full salaries, or just one or two largely absentee owners? If there are multiple owners taking larger salaries, then the benefit of not paying self employment tax will largely be lost if there are few profits.
If, on the other hand, it is a one person ownership situation, and that person will take all the profits and only pay themselves a small (but reasonable for the time invested working the business) salary, then the benefit of avoiding the self employment tax can be considerable.
The profit division question also is based on how many people are in the business as owners. If it is just one, this point is a non issue, since there is no one to split with. If there are two or three, working with equal shares and all working in the business as their full time means of income, it also isn’t likely to make a difference.
The advantage comes when there are multiple people who are owners, some who invest but don’t work in the business and some who do work in the business. In this case, there might be a reason to split the profits or losses differently than in accordance with the ownership percentages.
Although this doesn’t cover every possibility, hopefully it makes it clearer. If it is a one or two person business with no investors or complicated financing, and particularly if the owner will only work part time or be absentee, an S-Corp is a great choice.
If there are going to be multiple owners, or investors, or a more complicated partnership arrangement, then an LLC is probably the best choice.
Please note: The tax-related information provided here is for general informational purposes only and should not be construed as specific tax advice, nor does it establish a tax advisor-client relationship. Tax laws are complex, subject to change, and vary based on individual circumstances and jurisdictions. You should consult with a qualified tax professional, certified public accountant, or tax attorney regarding your specific tax situation before making any decisions or taking any actions based on this information and we assume no liability for your use of this information without seeking further consultation for your specific situation.
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