A business startup has several options for legal structure. Each has pros and cons; the LLC structure, which stands for limited liability corporation, is used to protect a new business owner’s personal assets from liability or seizure in the case of business losses. An S Corp is a type of small business tax structure that the IRS uses to determine federal income taxes. A corporation structure, either S or C, also protects the individual assets from business liability, such as debt.
Tax Planning
The IRS recognizes sole proprietorships, partnerships, and corporations, both S and C, for federal tax purposes. Once a business has formed an LLC, they can choose to be taxed federally as an S Corp; or they can remain sole proprietorships or partnerships. Deciding to structure a small business as an LLC is a decision that involves limiting the liability of the owners. Deciding on a request to be taxed as an S Corp is a tax decision. A single-member LLC will be considered by the IRS to be self-employed, and subject to self-employment taxes. The sole proprietor of an S Corp chooses to be paid a salary by the business.
Many small business owners find themselves jacks of all trades in the first years of their business. In an attempt to keep things as simple and user-friendly as possible, many choose to remain an LLC and be taxed as a sole proprietorship or partnership, rather than take on additional reporting and regulatory burdens as an S Corp. When running numbers, there may be significant differences in taxes owed due to Social Security, Medicare, and self-employment taxes.
Income Requirements and Differences
LLCs have members; S Corps call their members stockholders. In both structures, the individual reports federal income tax on profit made from the business on their individual income tax. The savings for S Corps comes with the designation of a salary or wages for the member. A single-member LLC with a profit of $100,000 pays Medicare, Social Security, and Self-Employment taxes on the entire profit. In an S Corp structure, a single member can receive a salary of $75,000 with a distribution of $25,000. The same amount of income is reported on federal taxes, but the profit doesn’t require payment of Social Security/Medicare; additionally, the self-employment tax is not owed on a salary from a business.
In the S Corp structure, business owners have the option to not distribute profit to their members or shareholders; instead, they can turn the profit back into the business. This allows business flexibility, while still paying members a salary. Members remain responsible for federal taxes on their income from the business, regardless of whether the profit was distributed.
An LLC Can Also Be an S Corp
Many or most LLCs can elect to be taxed as S Corps, but there are some guidelines on eligibility. An S Corp can have no more than 100 shareholders and only one class of stock. The shareholders can be individuals, estates, trusts, or non-profits; all shareholders must be US citizens. The IRS does look at salaries paid to S Corp stockholders. This is especially true for an LLC which has previously been a sole proprietorship. Salaries need to be in line with industry standards for the IRS to consider the structure valid. An LLC that has been taxed as a sole proprietorship in previous tax years can request from the IRS consideration for S Corp status in subsequent tax years.
In addition, an S Corp must be engaged in producing goods or services to other businesses or consumers; as opposed to accumulating mostly passive income, which is not allowed. No more than 25% of the income from the business can come from passive forms. As an example of passive income, you think of real estate investment earnings. While the S Corp structure does require additional reporting for tax purposes to the IRS, and additional initial structures when setting up the corporation, the IRS does allow cash-based accounting with no inventory management for resale, which many find an easier system for accounting when first starting a business.
Starting Up Your Startup
To set up the structure for your business, first register the entity in your state. Then request from the IRS consideration as an S Corp for federal taxation. While the reporting and regulatory requirements may involve hiring experts to ensure compliance, the savings can be considerable; most especially for a cash-strapped new startup business.
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