The limited liability corporation, or LLC, is designed to combine the flexibility and simplicity of a basic partnership with the protection of a corporation. “LLC” stands for “Limited Liability Company” and owes its name to the fact that the members (owners) of the LLC are not personally liable for the debts and liabilities of the business.
LLCs are ordinarily taxed as “pass-through” tax entities, meaning no income taxes are paid at the business level. Instead, business profit or loss passes through to the owners’ personal tax returns. By default, an LLC is taxed as a sole proprietorship if there is only one member and as a partnership if more than one owner.
An S-Corporation is not a Business Entity but a Tax Classification
People are always surprised to learn that an S-corporation is not a business entity, but a tax classification. Both LLCs and C-corporations can choose to be taxed as an S-corp. An S-corp doesn’t pay corporate income tax like a traditional C-corp – avoiding the dreaded double taxation. Double taxation stems from the corporation paying tax on all profit generated and the owners being separately taxed on income they received from the company. An S-Corp designation, like an LLC partnership, is a pass-through tax election with income, losses, deductions, and credits reported on the owner’s personal tax returns.
Choosing a Business Entity
When choosing a business entity, the founder must first choose between a sole proprietorship, LLC or Corporation. The second choice is how you want the business taxed. Since most small business owners prefer the simplicity of an LLC, let’s focus on why an LLC might want to elect S-corp status.
Not all LLCs qualify to be taxed as S-corps. The IRS sets strict requirements to qualify for S-Corporation status. An S-corp must be a US business with only US citizens/residents as owners. Neither LLCs, partnerships, or C-corps can be owners – and only certain types of trusts qualify. Additionally, an S-corp can have no more than 100 shareholders and only one class of stock/ownership.
In contrast, LLCs taxed as partnerships can have an unlimited number of members and different financial rights. Additionally, owners can include non-citizens/residents, corporations, partnerships, LLCs, and trusts.
One benefit of S-corp status is that it allows an LLC owner to be an employee, which could save money on taxes. When an LLC is taxed as a sole proprietorship or partnership, the owners must file as self-employed and thus subject to self-employment tax. The self-employment tax rate is 15.3% in 2022. An S-corp owner can be an employee of the LLC and get paid using a W2. This means only their salary is still subject to Medicare and Social Security taxes – not the entire business profit. To leverage this benefit, S-corp owners keep their salary low and let the additional profits pass to them at the corporate tax rate of 21%. The salary cannot be too low, as the IRS requires the salary be “reasonable.”
Cons of an S-corp
The downside is that there are more fees involved with an S-corp. The S-corp must manage the withholding and reporting requirements of an employer. If the LLC has employees other than the owner, this is not an issue. But if the only employees are owners of the LLC, a complicated payroll is unnecessary. Accounting fees will also be more expensive since two returns will have to be filed.
Navigating entity formation and the tax landscape is tricky and depends on the needs of the particular business. Consult an attorney or accountant before making such a far reaching decision. Always alert your estate planning attorney when starting a closely held business. An attorney can make sure your interests pass to your beneficiaries without interrupting the business. It is crucial that small businesses pass to a partner or family seamlessly and avoid probate in Surrogate’s Court. Too many small businesses fail because they had no business succession plan in place.