As a small business owner, choosing the right structure can be a daunting decision. With various options available, such as S corporations (S-corps) and Limited Liability Companies (LLCs), it's essential to understand the differences between them to make an informed choice. Furthermore, for those considering an S-corp, it's important to note that the deadline to file the election this year is approaching on March 15th, 2023. In this article, we'll explore the differences between S-corps and LLCs, discuss how an LLC can be taxed as an S-corp, and delve into the concept of reasonable compensation for S-corp owners.
S-Corporation vs. LLC
S-corporations and LLCs are similar in many ways, but they have some important differences. S-corps are a type of corporation that elects to be taxed under Subchapter S of the Internal Revenue Code, a type of pass-through taxation. This means that the company's income, deductions, and credits flow through to the shareholders, who report them on their individual tax returns. As a result, S-corps don't pay federal income taxes on their profits.
On the other hand, LLCs are not taxed as a separate entity. Instead, the income, deductions, and credits of an LLC flow through to the owners, who report them on their individual tax returns. This is known as "pass-through taxation." LLCs can choose to be taxed as a sole proprietorship, partnership, or corporation.
One advantage of S-corps is that they offer significant tax savings. Because the company doesn't pay federal income taxes, shareholders can avoid double taxation. Additionally, S-corps can pay their shareholders a salary, which is subject to payroll taxes, and then distribute the remaining profits as dividends, which are not subject to payroll taxes. This can result in significant savings for shareholders.
LLCs offer several advantages as well. They are simpler to set up and maintain than S-corps, and they offer more flexibility in terms of management and ownership structure. Additionally, LLCs don't have restrictions on the number or type of shareholders, whereas S-corps can only have up to 100 shareholders who are U.S. citizens or residents.
LLC as an S-Corporation
While LLCs and S-corps are separate legal structures, an LLC can choose to be taxed as an S-corporation. To do this, the LLC must file Form 2553 with the IRS and meet certain requirements, such as having no more than 100 shareholders and only issuing one class of stock. This can provide the benefits of pass-through taxation while also offering the advantages of an S-corp, such as significant tax savings.
S-Corporation Owning an LLC
It's also possible for an S-corporation to own an LLC. However, the tax implications of this arrangement can be complicated. If the LLC is taxed as a disregarded entity (i.e., it's treated as a sole proprietorship or partnership), then the income and expenses of the LLC flow through to the S-corp and are reported on its tax return. If the LLC is taxed as a corporation, then the income and expenses of the LLC are not included on the S-corp's tax return.
Reasonable Compensation for S-Corp Owners
One important concept for S-corp owners to understand is reasonable compensation. S-corp owners who also work for the company must pay themselves a reasonable salary for the services they provide. This salary is subject to payroll taxes, such as Social Security and Medicare taxes. The IRS defines reasonable compensation as "the amount that would ordinarily be paid for like services by like enterprises under like circumstances."
If an S-corp owner doesn't pay themselves a reasonable salary and instead takes a large distribution of profits, the IRS may reclassify the distribution as wages and subject it to payroll taxes. This can result in significant penalties and interest charges.
Consult With a Professional
Choosing the right legal structure is crucial for the success of a small business. LLCs can choose to be taxed as an S-corporation, and S-corps can own an LLC, but these arrangements can have complex tax implications. S-corp owners should also be aware of the concept of reasonable compensation and ensure that they pay themselves a reasonable salary for the services they provide. This can help avoid penalties and interest charges from the IRS.
Ultimately, the decision between an S-corp and LLC will depend on the specific needs and goals of a business. It's recommended to consult with a legal professional to fully understand the options and implications before making a decision. By doing so, business owners can ensure that they choose the legal structure that best fits their unique situation and helps them achieve their goals. Contact our firm for a free consultation about whether an S-Corp is right for your business.