New Business? LLC & S-Corp
Our video today is about LLC and S-Corp, and their advantages and disadvantages. Many of our clients ask us about this and wonder whether they should be an LLC or S-Corp, and what the difference is between them. See previous posts on this topic at these links: Part 1, Part 2.
The truth is, you can be both an LLC and an S-Corp. S-Corp refers to how your company is TAXED at the federal level. You can elect that when you register with the IRS, or at a later date. On the other hand LLC refers to the type of governance within your company. It is something that is selected when you registered at the state, not with the federal government or IRS, and your status as an LLC does not change just because you elect to be taxed as an S-Corp. You can register your company as an LLC or as a corporation in any state. However, the reason why many would want to form an LLC is because of its flexibility in governance and taxation.
For example, when you form an LLC, you get to choose how you want to be taxed. In this case, if you were a single-member LLC, the IRS, by default will treat you as the sole proprietor. If you have a partner, your company is taxed as a partnership, in which the company would have to file partnership tax returns, and everyone would get K-1’s to show much the company has made.
However, you can file an election with the IRS to be taxed as a corporation in one of two ways, even though your company is an LLC. One way is as an S-Corp and the other as a C-Corp. Most choose to be taxed as an S-Corp, since choosing to as a C-Corp has the disadvantage that dividends are taxed twice. I needn’t say more about that right now.
In most cases you would want to be an employee of your company. But owners of a company taxed as a sole proprietorship or partnership may NOT be employees of the company. Therefore, the company’s profits are allocated for tax purposes based on the proportion of ownership they have in the company. You cannot give more income to one owner just because that owner does more work than the other. The percentage ownership interest rules the allocation of profits for tax purposes.
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Sole proprietors and partnerships must also pay what is called a self-employment tax on the company’s income, whether you take out any profits as distributions or not. For example, if you have $100,000 in profits and you want to distribute $80,000 among the partners, each partner has to pay FICA (social security) on their share of the eighty-thousand, as well as on their share of the $20,000 left within the company.
If you are taxed as an S-Corp, you can be an employee that receives and pays FICA taxes on a salary (and your company matches your FICA payment), but the money that is left in the company for future growth is only subject to income tax, not FICA, reducing the taxes on the total income of your company.
Say you have members taking different kinds of positions, i.e. some members are more active in the company while others are silent and don’t contribute to daily operations. Under S-Corp rules, members that take an active role in the company’s operations are able to be paid a salary commensurate with that activity, while silent members can be limited to receiving distributions from what is leftover in your company’s profits after salaries are paid off, the details of which should be outlined in your company’s operating agreement.
These are some of the great advantages in governing your company under an LLC while electing to be taxed as an S-Corp. However, these can turn into negatives when you are expanding your company by going public or trying to receive venture capital. In the latter case, venture capitalists prefer companies to be corporations and be taxed as a C-Corp, but that is a discussion for another day.
Bottom line: we recommend governing your company under an LLC and filing taxes as an S-Corp, at least until you start to take on big time investors. There are several variations that you can learn more about by contacting your lawyer.
Entrepreneurs are going to save the world, and Argent Place Law wants to help. That’s why we are a team of entrepreneur-lawyers serving Entrepreneurs just like you. Think how great it will be to have a legal team with entrepreneurial experience on your speed dial so you can call us up and say, “How do we set up our company so we can we pay our active partners more than our silent partners?” Call Argent Place Law to find out.