Filing as an S Corporation vs. LLC: A Guide for Small Businesses
The verdict is in: There has never been a more exciting time for small businesses than the present. With more opportunities than ever to encourage long-term growth, success is a certainty for many new organizations.
However, before you get the chance to reap the rewards of an extensive, fulfilling career as a small business owner, you first have to complete the nitty-gritty of actually establishing such an operation.
Specifically, choosing business structures.
You’ve probably already heard about S corporations and LLCs, though it can be confusing for businesses to determine which is the best choice. Don’t worry; we’re here to help you out. Stay tuned as we guide you through the differences, from legal structures to tax statuses.
What is an S Corporation?
Businesses who file as an S corporation are taxed as a pass-through entity, preventing them from needing to shell out corporate-level double taxation. Still, you can’t choose this structure right out of the gate; to do so, you need to have already registered as either an LLC or as a C corporation.
Furthermore, small businesses need to meet certain criteria before they can qualify as an S corporation. Here’s a brief look at these rules:
- ● You must operate in the U.S.
- ● You’ve filed as an American corporation with the IRS.
- ● You have between 1-100 shareholders.
If you fulfill these points, you can file under the S corporation tax election. Doing so means that all credits, deductions, losses and profits — in other words, all tax liability — belong to the shareholders or members.
Here’s another important note: Business owners (also known as “shareholders” if under an S-corp) are considered employees of their own company. As such, you’ll have to pay yourself a reasonable salary — we’ll get to that later.
What is an LLC?
A limited liability company (LLC) is one of the business structures designed with certain protections in mind for owners — or “members” — of small businesses: most notably for their personal assets.
For instance, say your business is suddenly presented with a crushing lawsuit. The plaintiff can only pursue the assets of your business — not your own or those of any other members of the LLC.
Small businesses have two legal structures to choose from when establishing an LLC, each altering how taxes are handled:
- ● Establishing as a Sole Proprietorship: LLC members receive profits — rather than the business itself — and report their income through self-employment tax.
- ● Establishing as an S corporation: Members must pay themselves a personal salary and distribute the remaining profits as dividends.
So, What’s the Difference?
It’s crucial for small businesses to understand the differences between these business structures before making a final decision. After all, even the slightest change can make incredible impacts in the long run.
1. Taxation & Fees
LLC: As an LLC, all income generated will be taxable. Since profits go directly to owners rather than the business, you’ll need to pay these self-employment taxes to the IRS:
- ● Social Security – 12.4%
- ● Medicare – 2.9%
When it comes to establishment fees, the costs are generally low, averaging about $500 total. Though they vary across each state, small businesses can expect to cover the following:
- ● $100 articles of incorporation fee.
- ● Yearly reporting fees.
- ● Accounting fees (if you hire help for tax and financial filings).
- ● Lawyer fees (if you hire an attorney to help produce the legal documents).
S Corporation: S-Corporation, like LLCs both enjoy the benefit from double-taxation avoidance. Shareholders may report all corporate deductions, income, losses and credits on their personal tax returns using Form 1120S.
The major difference here involves the fact that shareholders must be paid a reasonable income. As a result, the business pays its payroll taxes (which count as a business expense) and distributes any remaining profits back to the shareholders.
Now, fees are a bit more complicated with this business structure. Though it all depends on the size of the organization, as well as which state it operates in, you can still expect to encounter some of these fees:
- ● $100-$250 articles of incorporation fee.
- ● Lawyer fees, which will depend on the complexity of your S-corp’s structure.
- ● $500-$800 yearly reporting fees.
- ● Accounting fees (if you hire help for tax and financial filings).
- ● Insurance fees, depending on the size and type of your business.
2. Benefits of S Corporations Over C Corporations
While we’re here, let’s briefly uncover some of the differences between S corporations and C corporations: two business structures that are often confused with one another.
Though businesses can file under either, S-corps offer some encouraging benefits over C-corps, most notably including:
- ● Avoiding corporate-level income tax.
- ● A 20% qualified business income deduction for eligible S-corp shareholders.
- ● Losses that pass through to shareholders, who may use them to offset income.
3. IRS’ Reasonable Compensation Regulations for S-corps
According to federal guidelines, if you’re an S corporation, you’ll need to pay yourself and other shareholders a reasonable salary.
Determining how the IRS’s reasonable compensation regulations impact small businesses varies widely across business structures. Still, the following nine factors are most commonly used by the IRS to calculate reasonable salary:
- 1. Training and experience.
- 2. Duties and responsibilities.
- 3. Time and effort devoted to the business.
- 4. Dividend history.
- 5. Payments to non-shareholder employees.
- 6. Timing and manner of paying bonuses to key people.
- 7. What comparable businesses pay for similar services.
- 8. Compensation agreements.
- 9. The use of a formula to determine compensation.
Resources such as indeed.com, monster.com, salary.com and other compensation surveys on specialized industries can help small businesses to calculate their average pay rate.
4. Business Structure
LLC: You’re flexible to choose your members in an LLC as you would with partners in a partnership. The difference between an LLC and a partnership is the limited liability protection that members get from operating in an LLC.
Furthermore, an LLC has no limit on the number of members — or owners — it may have; these members aren’t required to be U.S. citizens. Small businesses established as LLCs can even be owned by another corporate entity altogether.
S Corporations: A bit more complex, S corporations too has limited liability protection for its shareholders but it must have corporate officers and a board of directors, which LLC are not required to have. The first oversees the day to day business operations and the second facilitates in making executive decisions for the company. S-corps are also limited to 100 shareholders, all of whom must be U.S. citizens.
Having Your LLC Taxed as an S Corporation
With all this talk of legal structures, you might assume that your small business is beholden to one option for the remainder of its years. Fortunately, you have more wiggle room than you may think.
While most small businesses don’t stray far from their LLC's default taxation, another route is available: being taxed as an S corporation. In a sense, this is like combining business structures to get the most out of each. Don’t worry; this means that your business still exists as an LLC — you’ll just be treated as an S corporation for tax purposes.
Still, your business can only use S-corp tax status if it follows its specific regulations, such as paying members a reasonable salary and having a minimum of 100 members who are U.S. Citizens. If it sounds like a route that’s right for your business to take, you can start by making a special election with the IRS using Form 2553.
So, you’ve spoken with your closest advisors, combed through the ins and outs of the business structures available to you, and landed on your final pick. Congratulations! Now it’s time to begin forming your entity.
As always, the process will look different depending on which structure you chose and which state it operates in. Expect to encounter some of the following steps:
Forming an LLC
- 1. Business Title: Create a name for your small business. Ensure it isn’t the same as another pre-existing established LLC and doesn’t violate any state guidelines.
- 2. Registered Agent: If your LLC needs a registered agent to handle legal papers for your LLC in the case of a lawsuit, check with your local Secretary of State office to find a listing of eligible companies.
- 3. Articles of Organization: File articles of organization with your local Secretary of State office. These generally require a name and address for your LLC, a description of business operations, names of all owners and the contact information of your registered agent.
- 4. Operating Agreement: Create an operating agreement to be kept within your business records. This should outline specific business procedures regarding the addition and departure of members, member management, profit division and more.
- 5. Federal ID Number: LLCs with multiple owners require an employer identification number (EIN) for company identification purposes.
- 6. Business Licenses, Permits and Bank Accounts: Finally, check in with your state, county and city offices for any necessary permits or licenses before establishing your bank accounts and beginning operation.
Forming an S Corporation
- 1. Business Title: Create a name for your small business. Ensure it isn’t the same as another pre-established S-corp and doesn’t violate any state guidelines.
- 2. Assign a Board of Directors: These individuals will represent your business’ shareholders.
- 3. Issue Stock: S corporations can choose from preferred or common stock.
- 4. Articles of Organization: File articles of organization with the IRS and your local Secretary of State office. These generally require a name and address for your S-corp, contact information for the board of directors, shares information, the names of all owners and the contact information of your registered agent.
- 5. Corporate Bylaws: Create an outline detailing your business procedures and submit it to your local Secretary of State office. This should cover how shares of stocks are to be sold, how directors will be elected or removed, how meetings will be held and the procedure following an officer or director's death.
- 6. Form Filing: Lastly, be sure to file your Form 2553 with the IRS and — if your state requires it — with your registered agent.
Now that you know how to pick the perfect structure for your upcoming entity, it’s time to get down to business — literally. Though it’s easy for small businesses to drown beneath the piling requirements of payroll management, this no longer has to be your reality.
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