A lot of people have opinions about the best type of business entity to use when starting a new enterprise. The two types of entities most often discussed are probably S-corporations and limited liability companies. Today we want to give you some insight into these two very different types of entities.
Subchapter S
An S-corporation is nothing more than a regular corporation that has elected to be taxed under Subchapter S of the Internal Revenue Code. An “S election” allows corporations to avoid the problem of double taxation. Typically, corporations are taxed on their income, just like individuals. The problem is that when shareholders receive dividends, those payments are also taxed. So in effect, profits are taxed twice (once at the corporate level as income and then again at the individual level as dividends).
Subchapter S eliminates this problem and allows for what is called pass-through taxation. In other words, all the corporate income hits the shareholder’s bottom line directly and is not double taxed (i.e. there is no corporate income tax on S-corporations).
S-Corporations do have some drawbacks. First, only U.S. citizens or residents can own S-corporations. Second, individuals must own them. That means S-corporations cannot typically be part of a larger corporate structure involving holding companies or limited partnerships. One exception is that S-corporation can be owned by certain types of trusts.
Limited Liability Companies
A limited liability company (“LLC”) is a type of entity that is generally taxed as a partnership, but with an LLC you’re actually free to choose how you’ll be taxed. That means you can elect to be taxed as an S-corporation (which also means you have to comply with all the rules stated above).
The benefit to an LLC typically is that the management structure is very flexible, which simply gives you more options. LLCs avoid the rigid formalities of corporate law and allow you to structure your business in the way that best suits you.
The drawbacks
One argument for the use of S-corporation taxation over the default limited liability company taxation (i.e. partnership) is that shareholders receive income in a pass-through manner without having to pay self-employment tax. Before you get too excited, it’s important for you to understand that S-corporation regulations require any officer or owner who performs actual work on behalf of the corporation to be an employee.
That means red tape in the form of setting up a payroll system and paying FICA. While it is still true that part of your income can avoid all this because it is taxed as dividends, the IRS requires that income be treated as wages “to the extent the amounts are reasonable compensation for services rendered to the corporation.”
In short, if you expect to make a lot of money with your business venture and if a reasonable wage for your services isn’t too extreme, then making the S-election just might make sense.
Have you decided yet?
Didn’t think so! Let us help you. It’s what we do all day long. Making decisions like what type of business entity to use isn’t something you should do alone. We can help you flush out the pros and cons of the many options you’re going to have in almost every area of your business.
The Parents Estate Planning Law Firm, PC
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