I previously addressed some issues in choosing an entity-type for your small business. See here. From a purely legal perspective, I still recommend the LLC; however, sometimes tax implications make the corporate form preferable.
Forbes has a good discussion on what should small business owners consider before designating their business as an S-corp?
To understand the answer to this question, you have to first understand how the IRS classifies businesses. The IRS defines businesses as a sole proprietorship, partnership, C corporation or S corporation. The IRS has no LLC tax designation. So, by default, a single-member LLC is taxed as a sole proprietorship while a multimember LLC is considered a partnership. The key phrase is “by default,” because an LLC can choose to be taxed as an S-corp or C-corp. If an LLC selects an S-corp designation, it may save money on Social Security taxes and Medicare.
• An LLC taxed as a sole proprietorship compels the owner to 1) report business income and expenses on their personal income tax return, 2) pay personal income tax on company profits and 3) pay Social Security and Medicare taxes on said profits.
• An LLC taxed as an S-corp means the owner’s salary will be a business expense so the owner will report salary and other business profit on their personal income tax return. But, the owner will only pay taxes on their own salary (not on Social Security or Medicare).
So, what should I choose?
For most businesses, it only makes sense to register for S-corp status if you will save on taxes. To figure that out, first, identify a reasonable salary for someone with your job description. If any profit remains after paying yourself, then it is probably worth looking into S-corp designation. Just remember that your tax return will be more complex and, assuming you are the only employee, you will have to set up tax withholding.
New businesses have about 75 days after formation to elect as an S-corp. The above being said, each company is unique and circumstances different which require an analysis. Therefore, new businesses should not forgo this analysis at the outset before embarking on a venture.
As discussed, there are many similarities between LLCs and S-corps including, limited liability protection, separate entities and pass-through taxation. However, it is in the differences where an entrepreneur decides which type of company he or she prefers to start. For example, the IRS restricts S-corp ownership to 100 shareholders and U.S. citizens and/or permanent resident. Further, there are typically more formalities with S-corps, including adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings and keeping meeting minutes with corporate records. There are formalities for LLCs too, which include adopting an Operating Agreement, issuing membership shares and deciding whether it is a member-managed/manager-managed LLC — however, in my experience, LLC requirements are typically more of a recommendation than a requirement.
In order to thoughtfully perform an analysis, entrepreneurs will have to sit down with their accountant and startup lawyer to go through their goals, objectives (e.g., will there be an acquisition or merger in the future) and expected income totals to determine which type of business entity to form.