Without fail, at least twice a week a panicked business owner reaches out to me concerned that they were set up as a limited liability company (“LLC”) and heard that they needed to be an S-Corp. They aren’t sure what either means, but between Google and their well-meaning friends, they are in a panic! And while the internet (and your well-meaning friends) are full of “advice,” they don’t always know what is best for you and your business. If this is you, take a deep breath and then read on – in today’s post, we’re talking about the differences between LLCs and S-Corps, and the basic information you need to know about each.
Back to basics: What exactly are LLCs and S-Corps?
Much of the confusion around LLCs and S-Corps stems from the fact that most business owners don’t know what they are. Let’s change that.
A Limited Liability Company is a Type of Business Entity
A Limited Liability Company is a type of business entity. Once established, it is considered a person under the law and can transact business in its name (as opposed to in the name of its members). This allows its members to combine the liability protections of a traditional corporation with the flexibility provided to sole proprietors and partnerships. In general, LLC’s:
- Are one of the most common types of new businesses, especially for smaller, service-based companies
- Protect its members from personal liability for obligations incurred by company
- Are easy to form, less formal than a traditional corporation but provide more legal protections than being a sole proprietor or partnership.
- Members can choose how they want to be taxed
For many of the businesses I talk to, the LLC structure makes the most sense – they want their personal assets protected, but they also want flexibility. If you’re not an LLC or don’t think an LLC is right for you, let’s chat. Otherwise, keep reading!
S-Corporation (or S-Corp) is a Type of Tax Election
The IRS allows certain Corporations (and LLC’s, but we’ll get to that in a minute) the ability to elect to be taxed under subchapter S of the Internal Revenue Code. This means the corporation’s tax burden passes through to its shareholders, who claim earnings/losses on their personal income tax returns as opposed to being taxed on both the company’s earnings and shareholder distributions. These types of corporations are called S-Corps and to qualify the company:
- Must be a domestic Corporation
- Have no more than 100 shareholders (shareholders may be individuals, certain types of trusts and estates but they may not be partnerships, corporations or non-resident aliens)
- May only have one class of stock
Classifying an LLC as an S-Corp For Tax Purposes
One of the benefits of choosing an LLC as your business entity is that you have flexibility in how you are taxed. The default classification is as a sole-proprietor (for single-member LLCs) or as a partnership (for multi-member LLCs). But, and here is where the confusion comes in, LLCs can elect to be taxed AS AN S-CORP.
So, what does that mean? Basically, that means that if it makes sense for your business, you can elect S-Corp status with the IRS. Let’s look at when it might make sense.
Taxation under a Sole Proprietor or Partnership Classification
Many small businesses, especially those run by soloprenuers with no employees, stick with the default classification. Why? It’s fairly straightforward and simple to administer.
- The LLC is a pass-through entity for tax purposes – essentially, that means that all profit/losses flow to the members.
- Members pay themselves via distributions and must file estimated taxes with the IRS.
- Because Members are responsible for all the taxes associated with the LLC (both payroll and income), they are subject to paying the “Self-Employment Tax”, which refers to the member paying a higher rate for their Social Security & Medicare taxes. This tax is due on all profits earned by the LLC.
S-Corp Classification for LLCs
An LLC can elect to be taxed as an S-Corp with the IRS. One of the biggest benefits for members filing as an S-Corp is that they are able to avoid the Self-Employment Tax because the LLC pays a portion of this tax on their behalf. Other things to keep in mind when choosing an S-Corp election:
- Members who are employed by the LLC must be paid a reasonable salary.
- Payroll taxes are assessed at the time the Member / Employee is paid.
- Because payroll taxes are only assessed on a member’s wages, the LLC’s remaining income may be taxed at a lower rate.
Determining How Your LLC Should Be Taxed
Now that you know the basics, which should you choose? That decision isn’t as cut and dry as many online commentators would have you think. When looking at how they want to be taxed, LLCs need to consider:
- The number of members
- How many W-2 employees the business has
- Annual revenue
- How the members intend to be paid (i.e. are you foregoing a salary during the first year or two as the business takes off?)
Smaller, soloprenuers may be better off with the default classification because of its simplicity, while businesses with higher annual revenues and multiple employees will want to avoid the self-employment tax. And, despite what you may read online, there is no cookie-cutter answer – what works for your business may not work for your friends, and vice versa. Your best bet? Make an appointment with Linden Legal Strategies or your accountant and talk through your goals (both short-term and long-term) to decide which strategy works best for you and your business.
This article is for informational purposes only and does not constitute legal advice nor does it create an attorney-client relationship. Always consult appropriate legal counsel for specific questions related to your business. Some states may consider this attorney advertising.
Linden Legal Strategies PLLC is a Richmond, Virginia-based law firm focusing on small business law and development. To learn more about how Linden Legal Strategies can help you start, grow and protect your business, or to schedule an initial consultation, contact Stinson.