Over the last year or two, I’ve been surprised by the number of clients looking to start businesses that have inquired about the viability of organizing their business as what is known as an S-Corp. For years, Limited Liability Companies (“LLCs”) seemed to be the popular business entity of choice for small business owners. Lately, more and more entrepreneurs are examining whether S-Corps offer the same liability protection with less of a tax burden. While these concerns are important, they aren’t the only ones that should be considered when determining the right legal entity and tax designation for your business.
Technically, an S-Corp isn’t a formal business entity but is rather a tax designation, taking its name from Subchapter S of the Internal Revenue Code. A business can technically become a C-Corporation (C-Corp) or an LLC and choose to be taxed as an S-Corp (more on this later). While there are many businesses that can operate as either an LLC or an S-Corp, there are specific reasons where it makes sense for some businesses to operate as LLCs and others to operate as S-Corps. Even though one can change business forms or the way those business forms are taxed it is better to establish early on what business form is better for your long term planning so as to minimize expense and achieve your objectives more efficiently.
There are a few similarities between LLCs and S-Corps that make them attractive business entity choices. First, LLCs and S-Corps protect business owners by limiting their liability. As opposed to sole proprietorships (a lone business owner who has not formed a legal entity for their business) and partnerships (two or more people who have not formed a legal entity for their business), LLCs and S-Corps limit a business owner’s liability to the initial investment they make when forming their enterprise. For example, if you as a business owner, along with your partner, funded your LLC with twenty thousand dollars and later got sued by someone for fifty thousand dollars, the most either of you would be liable for personally would be your initial investment of twenty thousand dollars. Your creditors would have to collect the rest from the profits of your business. Secondly, LLCs and S-Corps are considered corporate entities separate from the individuals that run them. Therefore, as long as, you as a business owner, comply with corporate formalities and keep your business and personal affairs separate, your business’ creditors can’t go after your house, car, or other personal assets. This means you as a business owner should have a separate bank account for your business, sign legal documents as an owner of your business, and keep records of meetings where business decisions were made. Another similarity between LLCs and S-Corps is that either business entity does not have to be taxed in addition to the owners or shareholders of the business.
LLCs tend to be easier and less expensive to establish than S-Corps. In addition, LLCs often require fewer formalities and maintenance than S-Corps. The most important step to starting an LLC (in New York) is filing the Articles of Organization. Items required for the Articles of Organization include the name of the LLC, the county in which the LLC is located, and the address for service of process to the registered agent. Businesses elect S-Corp status by filing IRS Tax Form 2553 which must be signed by all of the corporation’s shareholders. There cannot be more than 100 shareholders in an S-Corp, all of which must be United States citizens. S-Corps cannot offer more than one class of stock to shareholders and once established must abide by requirements to conduct meetings, record minutes, issue resolutions, and make available financial statements. These requirements give outside investors more confidence in substantiating the value of S-Corps while also ensuring liability protection due to the demonstrated separation between the business entity and ownership.
The main advantage of an S-Corp over an LLC is tax savings. Owners of an S-Corp can pay themselves a reasonable salary. Any profits earned by the S-Corp can be paid as dividends to the owners as shareholders to the S-Corp. The amount received in salary would be subject to the payroll tax rate while the amount received in dividends would be subject to the lower dividend tax rate (currently 15%). S-Corps are an attractive option for businesses in industries where the average salary for employees in that field is lower, increasing the portion of a shareholder’s income subject to a lower tax rate. The IRS pays close attention to the salaries S-Corp owners pay themselves because of the potential for abuse that exists. Therefore, S-Corp owners should work closely with an accountant to ensure that the salary they receive from their business conforms to industry standards. LLCs are preferable to S-Corps in high salary industries where the benefit of tax savings does not justify both the added cost of setting up an S-Corp as well as the additional administrative burden to maintain compliance.
As mentioned earlier, both C-Corps and LLCs can elect to be taxed as an S-Corp. Businesses just starting out are tempted to form LLCs to start, while worrying about S-Corp election later, since maintaining an LLC it is less expensive. In most cases, there is no downside to this approach. However, establishing the business as a corporation taxed as an S-Corp will be more attractive to outside investors, especially in fields like film production. Below please find guidelines suggesting whether an LLC, S-Corp, or C-Corp is the appropriate business entity or taxation choice.
LLC or S-Corp or C-Corp Cheat Sheet
Control/Ease of Operation + Low Cost of Setting Up Entity = LLC
Control/Ease of Operation + High Salary Industry = LLC
Control/Ease of Operation + Low Salary Industry = S-Corp
Looking To Bring On Investors + Avoid Double Taxation = S-Corp
Looking To Bring On Investors + More Than 100 Shareholders = C-Corp
Looking To Bring On Investors + Any Shareholder NOT U.S. Citizen = C-Corp
Looking To Bring On Investors + More Than 25% Passive Income = C-Corp