Every new business owner faces the daunting task of choosing which type of entity structure best fits their business. S corporations and Limited Liability Companies (LLCs) both provide for the owner’s protection from creditors related to the debts of the business as well as liability from the actions of the other owners or shareholders. Plus, many small business owners prefer the flexibility of passthrough taxation provided by S Corporations and LLCs. But while taxation plays a large role in entity determination, it should not exclusively be the determining factor.
Here are some of the key tax and nontax considerations when deciding on an entity structure.
S Corporations are limited in number and type of owner. Only U.S. citizens and residents can be owners of an S corporation. Additionally, the number of shareholders is limited to 100. For purposes of this limitation, a husband and wife are treated as one owner. Estates and certain trusts are permitted to own shares in an S corporation.
LLCs have significantly fewer restrictions when it comes to ownership. While an LLC owned by one person is disregarded for tax purposes, LLCs can have an unlimited number and type of owners. The default tax classification for a multi-member LLC is a partnership.
Compensation of owners working in S corporations and LLCs is another area of differentiation. S corporation shareholders actively working in the business are employees of the entity and should be compensated as such. Accordingly, the S corporation will pay the shareholder employee a salary and withhold income taxes and Social Security. The shareholder employee will then be issued a W-2 at the end of the year.
This raises the issue of reasonable compensation. How much salary should an S corporation shareholder be paid versus allowing the profit of the company to pass through to their personal tax return as reported on their Schedule K-1? A number of factors should be considered when determining whether a salary is reasonable, such as the hours worked, services rendered, and industry guidelines.
Conversely, LLC members are treated as partners in a partnership and cannot be paid a salary. Payments for services rendered would be treated as guaranteed payments, which are a means of paying a preferential allocation of profits to a particular LLC member. Guaranteed payments and net profits from an active trade or business conducted by the LLC would be subject to Self-Employment Tax. While S corporation shareholders can possibly satisfy their federal income tax liability through payroll withholding, LLC members are required to pay quarterly estimated taxes.
Income and Loss Allocation
The allocation of income and losses to S corporation shareholders is more restrictive than that of LLC members. S corporations are limited to one class of stock. Income and losses from S corporations are allocated on a per share, per day basis. Any preferred allocation could be deemed to be a second class of stock and invalidate the company’s S election. Voting and nonvoting common stock are considered one class for this purpose.
LLCs offer greater flexibility when it comes to allocation of profits and losses. Any method that has substantial economic effect is permissible.
Pass-Through Loss Deductions
Owners are limited to deducting pass-through losses up to the amount of their basis. Losses in excess of basis are suspended and carried forward until the owner’s basis has been restored. LLC owners are at an advantage in this regard. They are able to include in their basis their proportionate share of the debts of the company.
S corporation shareholders do not have this ability even if they have signed a personal guarantee. An S corporation shareholder can only increase their basis relative to a loan they have actually repaid or monies they have loaned to the company. Those who have used their debt basis to deduct losses are often surprised to learn that the repayment of personal loans can be recaptured as ordinary income.
When choosing an entity structure, business owners should consider both short and long range plans for their business venture. One size does not always fit all. LLCs can offer more flexibility and less administrative burden for a small business just starting out. If future events necessitate a change, it is much easier to move from an LLC to an S corporation than vice versa. A change from an S corporation to an LLC could result in a taxable event for the owners.
Please contact any member of Kreischer Miller’s Tax Strategies group for assistance with choosing the entity type that best fits your business goals.
Jeffrey W. Clark can be reached at Email or 215.441.4600.
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