When working with new companies, this question is usually at the top of the list. Hopefully, this can help serve as a guide to help you make a more informed decision. This is a very broad overview to give you some sense of the differences and advantages/disadvantages of each.
What sort of entity should we be? S Corp or LLC?
I should distinguish that you are asking about two separate things here. The first, what type of legal entity should you be. The second, what tax classification should you elect. Limited Liability Company (LLC) is a legal entity type. S-Corporation is a tax classification.
Your options here are really between whether you should form an LLC or Incorporate (form a corporation). Both offer protection of your personal assets against business obligations. So long as you keep your personal assets separate from your business assets, either entity type will protect your personal assets (home, personal savings, retirement accounts, etc.) in the case of business debts going into default, monetary lawsuits, bankruptcy, etc. With that being said; which is right for you? The short answer is that you will most likely want an LLC. I would only recommend incorporating if you plan on doing some or all of the following:
- Raising significant capital through venture funding or high-level investors who will require equity in the company.
- Offering early employees equity in the company as a way to offset lower initial salary. For example, take an entry-level office assistant who could make 30,000 in an established company. You may offer 20,000 per year plus 2% equity to keep your cash obligations lower.
- Eventually taking the company public.
- Need the ability to make frequent changes in the equity structure.
If you plan on doing any of those with your company, maybe consider incorporating. If not, go for the LLC.
LLC vs. Corporations at a glance
- LLC Pros
- Easier to manage and maintain
- Less costly to setup
- Minimal regulations and reporting requirements
- Best suited for small-to-medium business
- LLC Cons
- There is no company stock so equity/ownership is harder to transfer
- Corporation Pros
- Stock shares are issued so ownership is easily transferred
- Any high-level investor will require you to be a corporation
- Required to become a publically traded company
- Best suited for large companies or companies looking to grow large
- Corporation Cons
- Strict regulation and reporting requirements
- Inflexible management of the company
- More costly to setup
Now that you have picked your legal entity, it is time to decide how you want to be taxed. This is where the S Corp designation comes into play. Whether you decide to form an LLC or a corporation, either can elect the S Corp tax classification. If you choose to incorporate, your only tax class options are C-Corp or S Corp. C-Corp is the traditional tax structure for corporations but we will ignore it. You will almost certainly not want to elect C-Corp status because your earnings are taxed at the corporate level and the personal level, known as double-taxation. So we will ignore C-Corp. Since you most likely have chosen to be an LLC, I will go over that first since the S Corp designation applies to either LLC or Corporations.
There is no “LLC” tax classification. When you form an LLC, you are taxed as one of the tax classes which are: Sole-Proprietor, Partnership, S Corp, C Corp. If there is only one owner (called members) of an LLC, then you are defaulted to sole proprietor. If you are an LLC with more than one member, the IRS defaults you to be taxed as a partnership. So if all you do is establish your LLC and generate an EIN (employer ID number) from the IRS, you will automatically be taxed as a sole proprietor or partnership.
How are partnerships taxed:
Partnerships are not taxed at the business level. Instead, the earnings or losses are passed down to the members’ individual tax returns and taxed at the personal level according to their ownership percentage. So let’s assume you and your partner are 50/50 owners.
- The company earns 500,000 revenue and has 300,000 business expenses
- Partner A reports 100,000 income on their personal return
- Partner B reports 100,000 income on their personal return
- Each partner pays state/federal income tax on their own amount AND employment taxes on their entire individual portion
Seems easy enough so why wouldn’t I just use the default tax class? Because S Corp status can potentially save you tens of thousands of dollars on the employment tax portion.
Employment Taxes (a.k.a FICA, a.k.a. Social Security and Medicare):
In traditional companies, employers and employees split the burden of employment taxes. Employers pay half (7.65%) and employees pay the other half (7.65%) totalling 15.3% on wages paid. As an owner of your own business, you are responsible for paying the entire 15.3%. The IRS views all income from a partnership as income so from our previous example:
- Partner A will pay 15,300 in employment taxes on 100,000 (15.3%).
- Partner B will pay 15,300 in employment taxes on 100,000.
- Total employment taxes are 30,600
S Corp election will save you money on employment taxes. Here’s how:
S Corps allow owners to save money on employment taxes by, first, paying themselves a “reasonable salary” and then reporting the rest of the income as an ownership distribution. Distributions are not subject to employment tax. So from our previous example:
- The company has 500,000 in earnings and 300,000 in operating expenses
- Partner A can make a case for a “reasonable” salary of 50,000
- Pays 7,650 in employment taxes (15.3% of 50,000)
- Partner B has a reasonable salary of 50,000
- Pays 7,650 in employment taxes
- Partner A claims 50,000 in distribution. Does not pay any employment tax on that 50,000.
- Partner B does the same.
- Total employment taxes paid is 15,300. Half of what would have been owed as a partnership.
If I’m saving that much money, then I am going S Corp (right?):
S Corps will require a little bit more effort on the financial/bookkeeping side. You will likely need to use a payroll service provider. You will need to set up tax withholding accounts. You will be liable for unemployment insurance (a few hundred dollars). So it definitely adds a few costs over being taxed as a partnership. It will require some knowledge of the requirements to make sure your company stays compliant with the rules. Are the savings worth it? Yes. But be prepared to learn more about S Corp than you may have anticipated.
So should I be taxed as a partnership or an S Corp:
That should be determined based on what you think you will really be earning. If you expect to make just enough to pay the owners’ cost-of-living, then the extra steps for S Corp are probably not worth it. If, however, you expect to make a substantial income from your company in the first year, then you will definitely see fairly substantial savings even in year one.