Ready to dive into a quick "advanced" lesson?
Spoiler alert: It all has to do with taxation!
Starting your own business is an exciting journey, and one of the first major decisions you'll face is how to structure your company. Selecting the right legal and tax structure for your business impacts your financial health, tax obligations, and operational flexibility. Understanding when and why to consider each option is key to your business’s success. For many solo entrepreneurs, forming a Limited Liability Company (LLC) is a popular option. However, some may be advised to have an S corporation instead. What does this mean?
The term "S corporation" refers to a tax designation, meaning how an entity chooses to be treated for income tax purposes.
Each entity has a "default" way that it is taxed. LLC's are normally taxed as pass-through entities (as partnership for multi-member or as a sole proprietorship for single-member). Corporations are typically taxed as a separate entity from its owner(s), which leads to what is commonly referred to as "double taxation." However, an entity can choose to be treated differently from the entity's business structure for income tax purposes (i.e., without changing the type of legal entity). In the case of an "S corporation", it means it's a entity (corporation or LLC) that chose to be treated as a pass-through entity (for tax purposes).
But, if an LLC is already taxed as a pass-through entity by default, why would it elect to be taxed as an S corporation?
The difference is in how owner-employees are treated. Under the tax code, an owner of a business taxed as a partnership who is also employed by the business is considered an owner. An owner of an entity taxed as an S corporation who works for the business is considered an employee. Employees must get paid a reasonable salary. For S corporations, only the salary is subject to FICA tax (Social Security and Medicare). Other net earnings that pass through to the owners are considered dividend income, which are not subject to self-employment tax.
In the case of LLC's, all of the business's profits pass through to its members' personal tax returns and are subject to self-employment tax for Social Security and Medicare.
While an S corp election can be beneficial, it comes with certain limitations. For example, only individuals who are U.S. residents can be owners, there can only be one class of ownership, the business must be formed in the U.S., and it cannot have more than 100 owners.
Let's sum up why some people choose to run their businesses as an S corp instead of a typical LLC:
1. LLC: The Blend of Simplicity and Flexibility. An LLC offers a blend of simplicity and flexibility, ideal for many business owners. It stands out for its “pass-through” taxation feature, where profits and losses are directly reported on your personal tax returns, bypassing corporate tax. This structure is particularly appealing for its minimal formalities and adaptable management, making it a popular choice for small businesses and emerging ventures.
2. S Corporation: Smart Tax Strategy for Growing Business. Although an S Corporation isn’t a different business entity, it’s a special tax status that an LLC can elect. It allows business owners to draw a reasonable salary while potentially reducing tax liability on additional profits distributed as dividends. This is especially beneficial for businesses that have evolved past initial growth stages and can balance salary with dividend distributions for tax efficiency. It is important to note that there are a number of restrictions on entities that can select S corporation taxation.
3. Selecting the Best Fit: Aligning with Your Business Goals. The decision between an LLC and an S corp should align with your specific business needs and aspirations. If you value a straightforward structure with fewer formalities, the LLC is a great choice. On the other hand, if your business is scaling up and you seek to optimize tax strategies related to salaries and dividends, an S corp may be the way to go. Both entities offer liability protection, but they differ significantly in their approach to taxation and administrative requirements.
TL;DR: As a small business owner of an LLC, choosing to be taxed like an S corporation is probably the least common option, but it is an option. Although an S Corporation isn’t a different business entity, it’s a special tax status that an LLC can elect (if it qualifies to do so). This tax election can offer potential tax benefits for small business owners, especially when the business generates significant income.
This is an over-simplified explanation of a complex legal/tax subject so if you are considering this information make sure you seek advice from a tax professional and/or legal advisor. Here’s to making an informed decision that paves the way for your business’s growth and success!
Kommentare