When you form a new business, one of the most important decisions you make is determining the legal structure of your business. For small- and medium-sized businesses, the best choice often comes down to setting your business up as a Limited Liability Company (LLC) or a corporation. For either structure, you may have the option of electing taxation under subchapter S of the federal Internal Revenue Code. The choice you make affects taxation of the business and its owners, as well as other aspects of management and operations. S Corporation vs LLC: Which one is right for you? Our business law attorneys explain.
LLCs and corporations both insulate business owners from liability. But the two business forms have very different structures and distinct management and operational requirements.
A common misconception is that “S corporation” refers to a specific type of business structure. The “S” actually refers to a specific subchapter in Chapter 1 of the Internal Revenue Code, which permits businesses meeting specific requirements to elect a special tax status. If specific requirements are met, a business with the structure of either a corporation or an LLC can elect to be taxed under the subchapter S statutory provisions. For a corporation or an LLC to elect subchapter S tax status, the business must meet these specific requirements:
Choosing to make your business an LLC or a corporation with S corporation tax status requires consideration and understanding of both the state and federal laws and regulations applicable to both types of business structures, as well as the subchapter S requirements. Kansas statutes governing the two structure types are separate. Both state laws are long and extremely complex. The best strategy for determining the right structure and tax status for your business is to discuss your options — and the pros and cons of each — with an experienced business law attorney.
In the absence of electing S corp tax status, an LLC is taxed the same way as a sole proprietorship or partnership, depending on the number of members (owners). The LLC’s income and profits pass through to the LLC members, who report the income and profits on their personal tax returns. LLC members pay self-employment tax (currently 15.3%) on their income. Any income the LLC generates is taxable income for the members.
Corporations pay taxes under specific federal and state laws. The corporation itself pays tax on income before distributing profits to shareholders, who then pay tax on the dividends distributed by the corporation. That results in the profits being taxed at both the corporate and personal level, which is often referred to as double taxation.
If an LLC or corporation elects S corp tax status, the business does not pay income tax, which eliminates double taxation. Business owners are shareholders and generally must be paid a reasonable salary as employees of the business. The business pays the employer portion of payroll (FICA) taxes. Shareholders pay their FICA share and do not pay self-employment taxes. They report their salaries as income on their personal tax returns. Profits are distributed as dividends, which have a lower tax rate than regular income. For these reasons, S corporation tax status may result in substantial tax savings for the business owners.
An additional tax consideration relates to the Qualified Business Income Deduction provided in the Tax Cuts and Jobs Act of 2017. The QBI or Section 199A deduction allows qualified business owners to take a tax deduction of up to 20 percent. Members of an LLC or shareholders in a business with S corp tax status may qualify for the QBI deduction, but the calculations differ substantially based on the tax status of the business. In both cases, determining eligibility and making the calculation can be very complicated.
An LLC choosing S filing status may benefit with regard to the QBI deduction on account of the difference in calculation. In some cases, choosing S tax treatment also may enable an LLC to qualify for the QBI deduction when otherwise it would not. Importantly, some businesses, defined as Specified Service Trades or Businesses (SSTBs), are not eligible for the QBI deduction at all. In addition, the QBI deduction is limited or not available to higher income taxpayers.
An LLC that chooses S corp tax status likely will face additional paperwork and administrative requirements, as well as more complex tax filings for both federal and state taxes — which likely means higher tax preparation costs. Whether the tax benefits outweigh the additional requirements and expenses is an important factor to discuss with your business formation and planning lawyer. Consulting with a knowledgeable attorney provides you with the assurance and confidence that you are making the right choices for your business.
Deciding on whether an LLC or corporation is the most advantageous structure of your business — and then deciding on whether to choose S tax status— is just one of many concerns that you should address in forming a new business. Whichever business structure and tax status you choose, you will need specific documents to implement your choice of business structure. Other issues also need to be addressed as well, such as regulatory compliance, employment matters, insurance issues, and contracts underlying initial and ongoing commercial transactions. Consulting with an experienced business law attorney is the best strategy for addressing the myriad of concerns and issues involved in starting a new business.
If you are comparing an S corporation vs LLC structure for your business or have other business law questions, we invite you to contact us. From our offices in Topeka and Lawrence, our Kansas business formation and planning lawyers at Sloan Law Firm assist owners of new and ongoing businesses with all types of issues relating to business management and operations, including business structure, taxation, commercial transactions, and employment law matters. Call us at (800) 369-6311 or use our online contact form to talk with us about your business needs.