The different types of business legal structures - Sole Prop, LLC, or INC
Most businesses begin as a sole proprietorship only because it is easier to start and requires less paperwork and regulatory overhead, and therefore generally costs less than filing as a Limited Liability Company (LLC) or Incorporation (INC).
However, each of these legal statuses has certain tax strategy advantages so it is important to carefully consider which status is: (1) the best legal structure for your business goals, and
(2) the most tax beneficial that keeps more money in your pocket annually.
LLC and Inc can Elect S-Corp Status
To add another piece to an already confusing decision on legal structure with either an LLC or INC, you can also elect either entity to be treated as an S-Corp with the IRS for tax purposes to save your business from paying more money to the IRS.
The Tax Advantage of S Corporations
For those choosing either the LLC or INC entity legal structure, an S Corp status allows the business to use “pass-through taxation” (ie, business income goes directly to owners instead of the corporation). This allows the business and owner to potentially save money, instead of the LLC’s profits being subject to payroll taxes, or an INC’s profits being taxed at the C-Corporation tax level and then subject to payroll taxes and taxable dividends when distributing the money out.
Brief Overview of an INC Structure
Protection from Liabilities
INC (Incorporated) status offers business owners (i.e., shareholders) the strongest protection from business liabilities as it is a separate legal entity from the owners and shareholders.
Shares and Shareholders
With an INC, the business can also sell shares of stock and offer employees a stock option plan. INCs may have any number of shareholders. Note that most public companies you may hold shares of stock in are generally structured as an INC too.
C-Corp and Double-Taxation
Keep in mind that when initially setting up an INC the IRS automatically treats the entity as a C-Corp and therefore all profits and losses flow to the corporation, where taxes are paid at C-Corp tax rates. While business expenses, retirement plan costs, and even employee benefits can be deducted by the corporation, the only way to extract money for a shareholder/business owner with a C-Corp is to pay themselves dividends or W2 salary. The dividends paid out to the shareholders, as well as W2 income paid to the shareholder/owner, is taxable income on an individual 1040. This is what is meant by “double taxation,” as the most common way for an owner to extract money from a C-Corp tax structure is to pay themselves dividends (taxed as individual dividend rates + Net Investment Income Tax) and pay themselves as a W2 employee paying payroll taxes on all of your W2 salary.
But what if you elected S-Corp status for your INC and we’re able to just pay payroll taxes on a “reasonable” W2 salary and the rest be taxed at your individual effective tax rate..?
Brief Overview of an LLC Structure
Flexible Business Structure
A Limited Liability Company (LLC) is the most common alternative to the INC. The business structure of an LLC has more flexibility than an INC, is easier to maintain without the required annual meetings and minutes, and still provides a good deal of protection from legal liability as long as the owner maintains a clear corporate veil by separating business and personal from the LLC accounting and operations.
Less Paperwork and Administration
LLCs require less paperwork to form than S Corps. For one thing, there is no board of directors. The LLC’s owners just file the Articles of Organization for the LLC with the state agency. LLCs are then required to get an EIN from the IRS and maintain the necessary licenses and permits just like INCs.
Tax Election Choices
An LLC has one class of shareholders/members, and has a choice on how it will be taxed…Sole Proprietor (SchC) filing, Partnership, S-Corp, or C-Corp. The tax election depends on your business and its needs.
LLCs are generally classified as pass-through entities and any profits and losses are passed through to the members of the LLC, and claimed on the member’s personal tax returns unless the LLC members elect to have the company taxed as a C-Corp where profits are taxed at the corporate tax rate.
How can electing S Corp Status with the IRS benefit me?
S Corp Election Does Not Change the Business Legal Structure
Becoming an S Corp is done strictly for tax purposes. A business stays the same legal structure of an INC or LLC status, but by electing S Corp status the business can elect to have their profits and losses pass through to their individual 1040 tax return to potentially save on paying more taxes than necessary.
Minimizing Payroll Taxes with S-Corp Status
The main reason for choosing to elect S-Corp tax status is to avoid paying payroll taxes on all of your profits and avoid double taxation.
Instead, an S-Corp election allows for business owners to pay themselves a “reasonable” salary, and only pay payroll taxes (Social Security, Medicare, Federal Unemployment, and State Unemployment tax) on just the “reasonable” portion of salary. This can be easily determined by taking an S Corp Compensation Test to determine what the “reasonable” salary should be.
Is electing S Corp Status the right choice for my business?
S-Corp Is Not Ideal For Everyone
While all S-Corps profits and losses are passed through to an individual 1040, making the S-Corp election is not necessarily beneficial to some businesses.
- Startups looking to take on equity investment,
- Businesses looking to offer equity compensation, or
- Partnerships looking to split profit/loss and equity interests.
These are just a few examples where an S-Corp election would not be the right choice.
Maintaining S-Corporation Tax Election
In order to maintain an S-Corp tax election, the business must be a U.S. LLC or INC with only one class of stock and less than 100 shareholders. All shareholders must be individuals, estates, or specifically qualified trusts. Each shareholder must consent in writing to the S Corporation election, and each shareholder must be a U.S. Citizen or permanent resident alien with a U.S. Social Security number.
S Corp must have a December 31st Year End
The tax year for an S Corp must end on December 31st.
Changing Tax Election with the IRS
Also, you can always update your tax election with the IRS at any time. There may be tax consequences for doing so, but you can always change your business's tax election with the IRS at any time by a majority shareholder vote.
Lastly, note that given the new 199A (Qualified Business Income Deduction) deduction, electing S-Corp status becomes potentially more beneficial to maximizing your tax savings depending on your industry.
Need Help?
We have been helping small business owners identify their business entities for over a decade. Plus, we advise on how to best set up your entity to maximize your tax benefits. Contact us today to start saving on your business and individual taxes tomorrow.
