Two of the most popular legal structures for small businesses are the LLC (Limited Liability Company) and the S corporation. Many small business owners have struggled over which is best for them.
However, you may not realize that the two aren’t mutually exclusive. It’s possible to have your cake and eat it too by forming an LLC and then electing S corporation status.
This is a particularly sound strategy if you have an LLC and the payroll taxes (self-employment taxes) on the owner(s) are high. Here we’ll break down some of the key details on why you should consider an LLC with S corporation election, and how you go about doing it.
An Intro to the LLC and S Corporation: Key Differences
Both the LLC and S corporation are well liked among accountants and small businesses because of their “pass-through” tax treatment. Unlike a regular C corporation, both of these structures do not pay taxes on the business’s profits. Rather, profits are passed along to the owner(s) and reported on their individual tax returns. In addition, both structures also help to separate the owners from the business and provide liability protection.
But there are some key differences as well. An LLC is typically much easier to run from an administrative standpoint. There are fewer state filings and forms, lower start-up costs, fewer formal meetings and documentation than with the C or S corporation. That’s usually a big advantage for small business owners who don’t want to be burdened by paperwork.
In addition, the LLC offers more flexibility in how owners can allocate the percentage of profits and losses among the owners. Let’s say you started a business with a friend and you each own 50% of the business. One year, your friend had something come up in his personal life and didn’t spend as much time on the business as you did. You both decided that the fair thing to do would be to give you 75% of the profits for the year.
However, if you had formed an S corporation, you would both still be taxed based on the percentage of ownership (i.e. you would be taxed on 50% of the profits; your partner on 50%…even though you had your own arrangement). However, the LLC does give you the flexibility to determine how you want to allocate the business’ profits and each owner will be taxed accordingly.
It may sound like the LLC is coming out miles ahead, but there’s one key advantage of the S corporation, and that’s with taxes. The S corporation gives you more flexibility in how earnings are paid to the owners. For example, with an LLC, the entire net earnings are passed along to the owner(s) in the form of self-employment income and are, therefore, subject to self-employment tax for social security and Medicare.
But with the S corporation, you have the option of dividing up earnings into wages/salaries and then passive income in the form of distributions. Only the wages/salaries are subject to the FICA tax for social security and Medicare. The distributions are not. However, keep in mind, as an owner working in the business, you have to pay yourself a reasonable salary for the job you do.
Don’t think you can get away with giving yourself a $20,000 annual salary and taking $150,000 in distributions.
Combining the LLC and S Corporation
Now, the interesting twist is that you can set up your business as an LLC and then make the election to have it treated as an S corporation by the IRS. From a legal perspective, your company is an LLC, not a corporation. That means you still get all the advantages of the LLC in terms of fewer filings with the state, as well as less paperwork and lower costs all around.
But then, in the IRS’s eyes, your business is an S corporation. You get the pass-through of income just like a sole proprietorship or partnership, and you get the added flexibility of distributing some of the company’s income as distributions not salary.
Therefore, potentially saving on social security/Medicare (i.e. SECA/FICA) taxes.
How to Set Up an S Corporation
If you’re interested in electing S corporation tax treatment for your LLC, there are a few other things to keep in mind. There are certain restrictions for who can form an S Corporation.
For example, shareholders need to be legal residents of the U.S. and they need to be individuals (i.e. not partnerships or corporations).
To file for S corporation treatment, you’ll need to file Form 2553 with the IRS. It’s relatively simple paperwork, but there are strict deadlines for when it needs to be filed. A brand new company has 75 days from the date of its incorporation (or LLC formation) to file.
If you’ve got an existing LLC and want S corporation status, it’s too late for your 2013 taxes. But you can qualify for the 2014 tax year as long as you get your paperwork in by March 17.
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