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An LLC or S-Corp?

Posted by Sean DiMercurio CPA CGMA on Oct 16, 2018
Sean DiMercurio CPA CGMA

Choosing a business entityQuite often we are asked "Should I register as an LLC or S-Corporation?".  While this question makes attorneys and CPAs cringe, lets break it down together and empower you to select the best entity type for your business!

The reason the question is confusing for attorneys and CPAs is because an S-Corporation is actually not a type of business, rather it's a tax election question not a legal formation question.  There are many articles written by non-attorneys and non-CPAs that cause a little confusion here!  The question you're really asking is "Should I be taxed as an S-Corporation?"

So, lets walk you through why you might want to be taxed as an S-Corporation and explain the legal formation process.

Why an s-corporation?

Lets first understand that businesses are typically taxed as a sole proprietorship, a partnership or an  S-Corporation.   Businesses that operate as sole proprietorships or partnerships must pay self-employment taxes (otherwise known as payroll taxes) of approximately 15.3% of the business profits (including any money that is taken out of the business as a guaranteed payment, salary or draw).  The exception is any passive income earned by the partnership.  Passive income is income you didn't have to actively work for, such as rentals, investment securities, etc.

However, if you are structured as an S-Corporation then the business profits aren't subject to the 15.3% self-employment/payroll tax.  The key is you can't have your cake and eat it too:  if you are structured as an S-Corporation, employee/owners are required to receive a paycheck (W2 income) and their pay must be reasonable (that is, fair for the work they are providing).

Legal Formation

While we aren't attorneys (and aren't offering legal advice), businesses are formed under state law (which is done under your state's specific corporation, limited liability company or partnership act).  A business is typically registered with the secretary of state, annual filing fees are paid and a registered agent is selected.  Once this process is complete you've legally formed your business.

Most business names end in either INC (a Corporation) or Limited Liability Company (LLC).  In our opinion the LLC structure will provide the best tax planning opportunity because typically you don't have to decide on the tax type until the first tax return is filed.  Even after that you can elect a new tax type in the future (subject to some fairly complex rules and high tax consequences, so don't do this without contacting us or working it out with your CPA first).  If you are planning on selling shares of your business, or operating in the tech industry, we highly recommend you speak with both a qualified attorney and CPA in order to ensure the business' structure is appropriate for your long term plans.

This ensures there is an opportunity to easily do some last minute tax planning before the first tax return (or subsequent returns) is filed.

Tax Formation / entity election

Once the legal structure is selected, you're able to choose what the tax structure will be.  Sometimes the tax structure is automatically determined based on the number of owners and legal formation type.  For example:

  • An LLC with 1 owner would automatically be classified as a disregarded entity for tax purposes
  • An LLC with 2 or more owners would automatically be classified as a partnership for tax purposes
  • A  Corporation with 1 or more owners would automatically be classified as a C-Corporation for tax purposes.


Sometimes the automatic tax election works and nothing more is needed.  However, if you want to elect S-Corporation status, Form 2553, Election by a Small Business Corporation, must be timely filed with the Internal Revenue Service.  If Form 2553 is not timely filed there are a few ways to still make the election - get in touch with us and we can walk you through these complex rules and regulations.

Compare

Now that we've walked through a high level overview, let's compare the differences between an LLC and a Corporation.

  LLC Corporation
Tax formation type/elections
  • Disregarded entity or sole proprietorship
  • Partnership
  • S-Corporation
  • C-Corporation
  • S-Corporation
Number of owners 1 or more 1 or more
How is the company taxed?

If the LLC is owned by 1 owner:

  1. Include on owner's tax return (no separate tax return is filed)
  2. Elect S-Corporation status (separate tax return is filed)
  3. Elect C-Corporation status (separate tax return is filed)

If the  LLC is owned by two or more owners:

  1. Automatic partnership treatment (pro-rata portion of net income or loss is included on owners' tax return - a separate tax return is filed for the business)
  2. Elect S-Corporation status (a separate tax return is filed)
  3. Elect C-Corporation status (a separate tax return is filed)

Two options are available:

  1. Elect S-Corporation status (a separate tax return is filed)
  2. Automatic C-Corporation status (a separate tax return is filed)
Required paperwork
  • Annual reports typically required
  • Ongoing paperwork is minimal depending on operating agreement requirements
  • Annual reports typically required
  • Ongoing paperwork requirements include formal board meetings, shareholder meetings and preparation of meeting minutes

 

Required meetings?

Meeting requirements depend on your operating agreement requirements, though we do recommend that you document all decisions made.

Formal meetings of the shareholders and/or board of directors are required.

 

A final word

Structuring a new business or entity is a complex matter.  We highly recommend that you speak with an attorney and CPA to understand what options are specially available to you based on your current situation.

have a question?

That's great!

Feel free to contact your THG team member or contact us to set up a entity structuring meeting (these meetings are FANTASTIC - you'll leave with a clear understanding of how to structure your business, how taxes will work for your business, what items you're paying for that are deductible and lots of pictures and drawings to review later).

Topics: Tax, Running your business