If you are starting a new business or if you are a sole proprietor and you are considering taking the next step of formally structuring your business, a common question you will have is: should I form an LLC or an S Corporation? This post will cover the main differences between an S Corp vs LLC, as well as their benefits and how to convert from an LLC to an S Corp.
What is the Difference Between a LLC and S Corp?
The LLC is a separate legal entity created by state filing and its members are protected from personal liability for business debts and claims. An LLC can have one member (single member LLC) or unlimited members (multi-member LLC). Members may include Non- U.S. citizens/ residents. As an LLC, you avoid being taxed twice as a business and an individual, instead taxes are based on the members portion of profits and losses reported on their income taxes. LLC taxes may vary from state to state. If you are planning to expand globally in the future, it’s a good idea to review our explanation of foreign corporation tax. LLC’s must file for a registered agent, pay annual fees, and notify the state of changes that may occur. Although not required, it is recommended for LLCs to have an Operating Agreement or a Partnership Agreement to provide guidance to its members on how the LLC should operate.
An S Corp is a traditional Corporation that fulfills the requirements of Subchapter “S” of the Internal Revenue Code (“IRC”). Like a traditional corporation, an S Corp is a separate legal entity from its owners and offers limited liability protection, so that shareholders do not typically become personally responsible for business debts and liabilities. It is a Corporation per se, meaning it must adopt bylaws, issue stock and hold meetings with shareholders while keeping meeting minutes. However, differently from a traditional C Corporation and just like an LLC, S Corps enjoy “pass-through” taxation, where the profits are passed on to the shareholders in proportion to their shares. An S Corp has some restrictions, that an LLC does not have. For example, it can have no more than 100 shareholders and all must be US citizens or green card holders. Another difference it that the owners of an S Corp are considered “employees” and must receive a “reasonable salary.” The IRS is constantly auditing S Corp businesses that show no payroll activity or that provide noticeably low salaries to its owners, which is why it is so important to have an experience tax and corporate lawyer help you structure your business. For an in-depth write-up on how much owner salary should S Corps pay, ready this tax article from Forbes.
Benefits of an S Corporation Versus the Benefits of an LLC
Choosing an S Corp vs LCC is beneficial for companies that are expecting growth early on and would like to obtain structure within the company. Wages paid to shareholders can be deducted as business expenses. Also, S Corp’s stocks are freely transferable, as long as, IRC ownership requirements are met. Moreover, S Corps are able to participate in tax-free reorganizations and can provide stock options and equity compensation to their employees.
The benefits of an LLC include ease of creation, no residency requirement, and minimal ongoing formalities such as annual meetings and meeting minutes
LLC Versus S Corp Tax Benefits
The examples below will provide you with a simple understanding of the LLC tax benefits and S Corp tax benefits. The California income tax deadline will provide you with appropriate dates to pay attention to as you start to file your personal taxes with your business.
LLC tax rules example:
You are a single member of an LLC and Sample LLC has income of $100,000 and expenses of $40,000. When filing taxes, your will report the Sample LLC profit of $60,000 and pay Medicare and Social Security on that total amount. Since you are a single member you will report that entire amount. If you were a member with 50% ownership, you would report 50% of the profits (in this example: $30,000) on your income taxes and pay Medicare and Social Security on the total amount of $30,000.
S Corp tax rules example:
You are an S Corp owner and Sample S Corp has income of $100,000 and expenses of $40,000. You pay yourself a salary of $40,000. The business has a profit of $20,000. When filing taxes, you will report $40,000 as wages and $20,000 of business income. Nonetheless, Medicare and Social Security will only be based on the salary of $40,000 (usually done through withholdings) instead of the total amount in an LLC.
Review the California income brackets to determine your income and tax bracket to understand how you will be taxed this year.
Benefits of Converting LLC to S Corp
Many companies will start as an LLC because its easy, less expensive and has many advantages. However, as your business grows the increases in salary and profits also increases the self-employment tax. In addition, you might want to provide shares to potential investors. Owners typically start thinking about adding a solo 401k account for contributions to their retirement plans.
It’s typical for a company to convert from an LLC to an S Corp when the self-employment tax level increases. However, it is important to review the rules and percentages based on your state. Each state may vary. As tax attorney in San Diego, CA we can review the right path for your company with a free consultation.