Business owners can adopt a variety of legal structures, including a general partnership, limited partnership, registered limited-liability partnership (LLP), limited-liability company, C-corporation, sub S-corporation, professional-services corporation, and professional services limited-liability company.
The most popular of these for small-business owners are the limited-liability company (LLC) and the sub S-corporation (S-corp). Why? Because, of the entities listed, these are the only two that provide liability protection for all of their owners from nearly all liabilities and eliminate taxation at the entity level on entity income. But between the LLC and S-corp, there are important subtle differences that business owners should consider carefully when deciding which form their business entity should take.
The LLC vs. the S-corp
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It seems common wisdom these days to “form an LLC” to operate a business. In some respects, the conventional wisdom works. From a personal-liability standpoint, an LLC is certainly better than the often-used (and ill-advised) d/b/a, or “doing business as” format. But the common wisdom is incomplete.
Why should a business be an LLC and not an S-corp? Unlike a d/b/a, an LLC and an S-corp are legal entities that are separate from their owners and that protect those owners from personal liability for most company debts, liabilities, and obligations. Which, however, is the best structure for the operation of your business? That decision hinges on two important considerations: management and taxation.
How to approach management of a business entity is a topic that requires much negotiation between the entity’s owners and operators, whose interests are not necessarily aligned. Apart from members of the Responsible Wealth Project, however, almost everyone can agree on how they want to approach taxes ― they want to pay less. This is where the LLC and S-corp differ and where, in most cases, the S-corp is a superior choice.
For most purposes, an LLC and an S-corp are considered “pass through” entities for purposes of taxation. In other words, neither entity, except in certain limited instances, pays entity-level income tax to either the IRS or the New York State Department of Taxation and Finance. Instead, the income of the entity is considered, for purposes of taxation, to be the income of the individual owners of the entity, and is allocated to them on a pro-rata basis according to their ownership percentage in the business, subject to limited adjustments.
This is a single-taxation regime, a wholly different concept from the C-corporation, which is taxed first at the entity level on its income and then taxed again at the shareholder level on its distributions.
Differences
Looking beyond the general single-taxation structure, however, the LLC and S-corp differ regarding the dreaded self-employment tax. That tax imposes on a self-employed individual a Social Security tax of 10.4 percent on all compensation up to $106,800 plus an additional Medicare tax of 2.9 percent on all compensation without limitation. In an LLC, if an owner is not considered a “limited partner,” all of the taxable income of the entity allocable to that owner will be subject to self-employment tax.
The current proposed regulation provides that an owner will not be considered a limited partner if that owner (1) has personal liability for debts of the entity, (2) has authority to contract on behalf of the entity, (3) participates in the business of the entity for more than 500 hours annually, or (4) is an owner of a service partnership such as, among other things, a law firm, physician practice, or consulting firm.
Practically, then, an owner will not be considered a limited partner in the event that owner takes any sort of active role in the business of the entity. In a vast majority of operating businesses; i.e., businesses which are not mere holding companies or real-estate holding companies, this exclusion subjects its owners to self-employment taxes on all of their allocable income.
An S-corp does not suffer the same drawback. An owner of an S-corp who performs anything more than minor services for the entity is generally considered an employee and, as an employee, is subject to self-employment taxes only on compensation for services rendered. Thus, an owner/employee of an S-corp has two categories of income from the entity to consider: compensation and distributed earnings.
Only the first category is subject to the self-employment tax. This can result in a substantial tax savings on that share of the employee/owner’s earnings which are not deemed compensation. For example, as a trial attorney in 1995, John Edwards characterized only $360,000 of his income as earnings, even though his S-corp made approximately $26 million. This resulted in a self-employment tax bill which was approximately $700,000 less than he would have paid by operating as an LLC. Newt Gingrich also employed the same technique in 2010 for a substantial savings in self-employment tax.
Obviously, this treatment of S-corps invites abuse, as employee/owners may be tempted to characterize a minimal amount of their income from the S-corp as compensation in hopes of avoiding tax on as much income as possible. The IRS is very aware of this potential for abuse and has stated that the amount must be “reasonable compensation,” a determination which is based on the individual facts and circumstances of each case.
Primarily for this reason, many new businesses are incorporating as S-corps instead of LLCs and are enjoying substantial tax savings as a result. It also costs $75 less to form an S-corp with the New York Secretary of State and, while an LLC must publish notice of its existence for six weeks in two major newspapers in its county of residence, an S-corp is not subject to that requirement, saving the owner about $300 or more at the outset.
Unless an operating business is disqualified from electing to be treated as an S-corp by having, among other things, too many shareholders, foreign shareholders, different classes of stock or shareholders which are not individuals, organizing as an S-corp is worth considering and likely a very wise choice for a new business. Owners of existing businesses currently operating as LLCs should reassess whether that structure continues to be right for them. If not, they may also take advantage of the S-corp structure by converting from their present form. All owners of businesses, new and existing, should consult with their attorneys and tax advisers to determine the best legal structure for them.
Douglas J. Gorman is a corporate and banking and finance practices attorney at the law firm of Hancock Estabrook, LLP. Contact him at dgorman@hancocklaw.com