When setting up a new business, arm yourself with all the facts before deciding what form of entity to choose. Because, whichever entity you choose for your business will have financial, legal and tax implications.
Business owners often narrow their choices down to an S-Corporation or an LLC. The S-Corporation is one which files an S-Election for tax treatment purposes. The S-Corporation is initially less expensive to form, because there is no publication requirement -a requirement to publish a notice of formation in two newspapers over 6 weeks. The annual franchise tax is based upon wages paid, from a minimum tax of $100 to maximum of $10,000. The Corporation files a separate tax return and this may increase accounting costs for the company.
An LLC is more expensive to initially file because there is a publication requirement. The cost to publish can add $350-$450 to the costs of formation. Additionally, similar to the Franchise Tax, there are annual fees based upon the number of members in the company. The annual filing fee is $100 multiplied by the total number of members or partners in the LLC with a minimum fee of $500 and a maximum fee of $25,000. Single member LLC’s must pay an annual filing fee of $100.
One tax advantage for a single-member LLC is that the company is a disregarded entity for tax purposes, so the activity of the business is reported on the member’s income tax return. For an individual, the income would typically be reported on Schedule C or Schedule E of Form 1040. An LLC with more than one member is usually taxed as a partnership, however, and a separate income tax return is
Some basic legal differences also exist between the formation of the S-Corporation and the LLC.
The S-Corporation provides personal liability protection for its owners. Owners are called shareholders and they are issued stock certificates. Shareholders elect directors, and they, in turn elect officers. By-laws and the business corporation law govern the entity. No foreign citizens or entities can be shareholders and no corporations or LLC’s can be shareholders. There is a limit to how many shareholders are permitted in an S-Corporation. The business corporation law is restrictive and provides shareholders with certain rights.
The LLC also provides an owner with personal liability protection. Owners are called ‘members’ and are ‘interest’ holders. They can be issued membership certificates or designated a percentage of membership interest. There is no limit to the number of members in an LLC. Any entity can be a member and there are no restrictions on foreign members.
An operating agreement and the limited liability law governs the entity. The limited liability company law is not as comprehensive as the business corporation law allowing the operating agreement to have significant control over the members and their business relationships.
Unequal distributions can be made to members and special allocations can be made. In addition, a non-equity owner may be given total voting and management control of the LLC.
It is important to understand the tax implications in these two corporate entities For example, the income of each entity passes through to the individual owners, whether an LLC or S-Corp, but in an LLC where the owner is an active participant in the trade or business, all of the income is subject to self-employment tax.
In an S-Corporation, Social Security and Medicare taxes (self-employment tax) are only paid on wages received from the S-corporation. Each entity has the ability to distribute assets to the owners as a tax-free return of capital, but in an S-Corporation, the owners must be careful of disguising compensation in the form of tax-free distributions, thereby avoiding the self-employment tax altogether.
If the owners in an LLC elect to be treated as a partnership for tax purposes and guarantee any debt of the LLC, this guaranteed debt adds to their basis in the partnership. In an S-Corporation, personal guarantees do not increase your basis.
In an S-Corporation, certain events may trigger the revocation of the S-election. If this happens, the corporation would be treated as a normal C-Corporation and many of the tax-related benefits of the S-Corp election would be eliminated. An LLC is treated as a partnership unless it elects to be treated otherwise, so there is no concern about revocation of elections.
An LLC is more advantageous if the LLC owns assets such as real estate which are expected to appreciate in value. The LLC has the ability to distribute out the asset to an owner and the owner takes the carryover basis in the property. In an S-Corporation, the distribution is made at fair market value and the S-Corporation immediately recognizes any gain upon distribution rather than upon the sale of the asset. If an LLC treated as a partnership redeemed the ownership interest of one of its owners for greater than book value, the partnership has the ability to step-up the basis of its assets. An S-Corporation does not have this flexibility.
In order to maximize the benefits of an entity for your business, it is important to talk with your legal counsel and accountant prior to forming any entity. Understanding the legal and tax implications of the entity you select is critical in operating your business in the future.
Partner, Jennifer Chadwick provides legal services in the areas of corporate, business and banking law. She is prepared to answer any questions pertaining to your personal business needs. You may reach her directly by calling 324.5721. Jason DeLaurentiis, CPA at DeMott & Smith also contributed to this article.