Soon-to-be business owners often wonder what type of legal entity is best when starting a business and whether a limited liability company or an s-corporation is appropriate.
Two of the most popular choices are limited liability companies (LLCs) and s-corporations (S-Corps). LLCs and S-Corps have many similarities, the biggest being “pass-through” taxation. This means that the LLC or S-Corp does not pay taxes itself, but rather distributes those profits and losses out to its owners.
Limited liability companies have the advantages of limited liability features of corporations and the tax efficiencies and flexibility of a partnership. Being a “pass-through” entity, LLC’s profits and losses pass through the LLC to the members. As with partnerships, members (the LLC owners) report the profits and losses on their individual tax returns. The LLC’s great advantage over a partnership is that the LLC limits the liability of the member to the member’s capital investment. This is different than operating as a sole proprietor or partnership because in those entities, the partners/sole proprietor are each liable for all of the debts of the company. The S-Corp operates in a similar fashion in that the shareholders’ liability is limited to the shareholder’s capital investment.
The similarities between the LLC and the S-Corp often make either a suitable choice. However, there are differences that should be noted. One difference is there are fewer restrictions on splitting profits within an LLC since members can distribute profits as they agree, without regard to the actual capital investment. In an S-Corp, all shareholders must be treated the same for profit sharing based on their respective ownership.
Another difference between an LLC and an S-Corp is taxation on “distributions.” In an LLC, the entire net income of the LLC is subject to a 15.3 percent self-employment tax. However, in an S-Corp, only wages (must be reasonable wages) of the S-Corp shareholder are subject to this employment tax. The balance of the S-Corp’s income is paid to the owners as a distribution and not subject to that tax. There can be potential tax savings by creating an S-Corp in this regard.
It may make sense to organize as an LLC and also elect S-Corp status. This keeps your business as an LLC from a legal standpoint but for tax purposes it is treated as an S-Corp. This gives the small business owner the added flexibility of an LLC with the tax advantages of an S-Corp.
It is important to note that other facts and circumstances go into determining which entity is appropriate. An experienced attorney can help you make an educated decision.
Information provided by Adam Doll, attorney at law, Hopkins and Huebner, P.C., 1009 Main St., P.O. Box 99, Adel, 515-993-4545, fax: 515-993-5214.