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The benefits of being a sole proprietor are well known; it is relatively simple from a legal and operating perspective. It also offers the plus of being a “pass-through” vehicle in terms of tax treatment, regardless of whether you are paid from sales, profit, as a 1099 contractor, etc. But, the big Achilles heel of being a sole proprietor in these litigious times is that your personal liability is very high if someone decides to sue for non-performance, damage to their business as result of your actions or advice, personal injury, etc. Most of our clients prefer to have some level of indemnification against personal liability when it comes to the activities of their business, and therefore require a different sort of legal entity within which to house their firm’s activities.
There are other choices, but the legal structures that most small businesses consider after rejecting being a sole proprietor are Limited Liability Companies (LLCs) and Subchapter S Corporations (S-Corps). With both legal structures, you get the benefit of the ‘pass-through’ in terms of income, and, the very important liability protection.
However, it is important to know the differences between these two types of popular legal entities. There is no right choice for all small companies, only the correct choice for your small business and your needs and abilities around regulatory requirements, profit distribution, operational ease and different tax implications. Decide which features are most important to you and your company, and then make an informed decision as to which legal entity suits you best. Whether it’s Sareen and Associates, or some other business services company, this is one of those moments when it’s probably a good idea to consult with someone that has experience in this area.
An LLC is a flexible business structure similar to a sole-proprietorship or a general partnership. LLC owners (members) can be one, a few or many. Members can be U.S. and/or foreign nationals. And members generally operate under an informal agreement.
An LLC doesn’t exist from the viewpoint of the IRS; it’s a sole proprietorship or a partnership for tax purposes. But, you should be aware that some individual states do charge LLC entities an income tax. Regardless, it does offer much more liability protection than a sole proprietor setup or a legal partnership.
From a legal perspective, the difference in liability between a sole proprietorship and/or a legal partnership and an LLC is striking. In a sole proprietorship and a legal partnership, each individual is responsible for 100% of the debt or results of litigation that the company incurs. In an LLC, each member’s liability is typically proportionate to their percentage of ownership.
An LLC is much easier to manage from a regulatory standpoint than an S-Corp. Fewer forms are required for registering the legal entity (read: lower start-up costs). Filing taxes happens annually on April 15 just as with an individual tax return: a single-member LLC files a 1040 and Schedule C like a sole proprietor. Members (plural!) in an LLC file a 1065 partnership tax return like owners in a traditional partnership. Members are able to pass company losses to their personal income reporting. There are specific situations in which the LLC lets you pass-through more losses than in an S-Corp. An example would be in the instance of an LLC used for real estate investments. Members of the LLC are allowed to add the total amount of the mortgage to their basis for the purpose of determining losses. Sareen and Associates has several clients that are real estate investment firms, and they employ this tax credit to considerable benefit.
However, one important thing to consider is that the IRS considers the owners of an LLC to be self-employed, and therefore subject to the 15.3% self-employment tax contributions towards Medicare and Social Security. The aggregate net income of the LLC is subject to this tax. No, that’s not a misprint.
In keeping with the more informal nature of an LLC, profit-sharing is distributed within an LLC as members see fit. The benefit of this is that different members might contribute different amounts of capital and labor, and the members can decide what percentage of the profits (or losses) go to each member on an ad hoc basis. The drawback to this is when members don’t allocate fairly, and there is no legal structure to prevent this sort of informal targeting of one or more members.
LLCs aren’t required to have a board of directors, stockholders, hold formal meetings and keep minutes, so again, less regulatory requirements. But, every LLC has a finite life – if any of the members dies, or declares bankruptcy (a sort of legal death), the LLC dissolves immediately thereafter. This can throw the business into chaos for a time.
From the perspective of the IRS, an S-Corp is ‘considered by law to be a unique entity, separate and apart from those who own it.’ This legal designation allows for a limit on the financial liability for which an owner (in this case, a shareholder) is responsible. Nevertheless, S-Corp shareowners should not be lulled into a false sense of security concerning litigation. The plaintiff, aided by a good lawyer, may be able to ‘pierce the corporate veil’ and go after your personal assets in a lawsuit. It’s important to bear in mind that having the designation of an S-Corp (or an LLC, for that matter) does not necessarily shield owners from tort actions such as accidents caused by actions of the companies or their employees/agents.
Every S-Corp is a corporation that has received the Subchapter S designation from the IRS. In order to get this designation, a business must first be chartered as a corporation in the state where it’s legally (not necessarily physically) headquartered, and then file the required documentation to be considered an S-Corp. We do this regularly on behalf of our clients; it’s fairly routine if you’ve done enough filings. We have also fixed previous filings that were done online, but badly, by our clients – insert your own judgments and conclusions here.
Befitting it’s stand-alone legal structure, S-Corps require regulatory boxes to be checked, things like scheduled director and shareholder meetings, recorded minutes from the meetings, adoption of, and updates to by-laws, stock transfers, records maintenance and more (see below for the required IRS filings).
One of the great features of the S-Corp is the tax savings for your business and your shareholders. Unlike a traditional corporation (C-Corp), an S-Corp has the ability to have profits and losses pass through to the shareholder’s personal tax return. The business is not taxed itself, only the shareholders. There are some important wrinkles to how you do this, of course. A good accountant can work with the tax code to make sure you don’t run afoul of those wrinkles. Something you don’t want to do is to attract the attention of the IRS as a potential perpetrator of tax fraud, so it’s best to consult with a professional on the tax credits available to you in an S-Corp scenario.
Do you recall that I previously mentioned that members of an LLC are subject to employment tax on all of the net income of the business? Big difference here – only the W-2 wages of the S-Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner (shareholder) as a ‘distribution’, which is taxed at a lower rate, and sometimes, it’s not taxed at all.
And some benefits that shareholder/employees receive can be written off as legal business expenses. But, if employee owns 2% or more of total shares, benefits like health and life insurance are regarded by the IRS as taxable income.
Unlike an LLC, if something untoward happens to member or shareholder, an S-Corp allows the business to live on. An S-Corp can continue doing business as usual if a shareholder dies, leaves the company, or sells his or her shares, etc.
One more thing that may or may not be important to you: If you think that your company will want venture capital in the future, VC firms generally like to deal with C-Corp entities. Converting an S-Corp to a C-Corp can happen in as little as a single business day, and it involves one piece of paper. The process is much longer and more onerous if you’re converting an LLC to a C-Corp.
Want a big dose of downside to the S-Corp? Here is a list of the IRS tax forms required from an S-Corp:
- Form 1120S: Income Tax Return for S Corporation
- 1120S K-1: Shareholder’s Share of Income, Credit, Deductions
- Form 4625 Depreciation
- Employment Tax Forms
- Form 1040: Individual Income Tax Return
- Form 1040-ES: Estimated Tax for Individuals
- Schedule E: Supplemental Income and Loss
- Schedule SE: Self-Employment Tax
- Forms 2553, 941 and 940
And these forms are due at different times during the calendar year. Some firms find this a real pain to keep up with.
Lastly, not all states are as friendly to C-Corp and S-Corp entities as other states. And, in fact, there are several states where the tax burden and regulatory requirements are above and beyond what the U.S. government requires. Talk with a CPA before determining which state to file in.
Ahh, the hybrid – Get an LLC and an S-Corp
There are many peripheral factors that could sway the argument for or against either an LLC or an S-Corp. With this in mind, Sareen and Associates sets up a LLC/S-Corp hybrid entity for many of our small business clients. This works very well in terms of covering many different business scenarios. The LLC retains a great deal of its innate flexibility, and remains a limited liability company from a legal standpoint, but from an IRS standpoint, it’s treated as an S-Corp, with all the requisite tax advantages. Ask us about this option.