Choosing the right business structure for your small business can seem like a daunting task. After all, the decision can have pretty significant implications, from how much you pay in taxes to how much paperwork you need to contend with.
March 15th is the deadline for existing businesses to elect S Corporation status, making it a good time to examine this business entity.
You may have heard that the traditional C Corporation is overkill for most small businesses and results in higher overall tax payments through something known as double taxation. That’s because when it comes to taxes, a C Corp is a separate taxpayer that files its own federal and state (where applicable) tax returns.
This means that profits are first taxed with the corporation. Then if the corporation decides to take that profit and distribute dividends to shareholders, the dividends are taxed again (this time, on each shareholder’s personal tax statement).
The LLC (Limited Liability Company) and S Corporation are popular structures for small businesses since they avoid this double taxation burden. With these business structures, the company is taxed like a sole proprietor or partnership, meaning the company itself doesn’t file its own taxes: all company profits are ‘passed through’ and reported on the personal income tax return of the shareholders (S Corporation) or members (LLC).
If you’re interested in setting up an LLC or S Corporation for your business, you’re probably wondering which business structure is right for your business. While circumstances vary among individuals and individual businesses, here are some general guidelines to help you understand the differences and their impact on your business.
As always, you should consult with a tax advisor or CPA to discuss the specifics of your own situation:
Both the LLC and S Corp will separate your personal assets from any liabilities of the company (whether from an unhappy customer, unpaid supplier or anyone else who might pursue legal action).
An S Corporation actually begins as a C Corporation. After the corporation has been formed, it can elect ‘S Corporation Status’ by filing Form 2553 with the IRS in a timely manner in order to get pass-through tax treatment (more on the deadline later). This means that the S Corporation involves the formalities and compliance obligations of the C Corporations.
If you incorporate as an S Corporation, keep in mind that you’ll need to set up a board of directors, file annual reports and other business filings, hold shareholder’s meetings, keep records of your meeting minutes and generally operate at a higher level of regulatory compliance than your business might need or want to deal with.
With the LLC, this isn’t the case. LLCs just use an informal operating agreement. Think about how much formality you want to deal with. In some cases, the S Corporation can seem too burdensome for the small business or solo entrepreneur.
The IRS places restrictions on who can be a shareholder of the S Corporation. An S Corp cannot have more than 100 shareholders (of course, this may not be too significant for the small business). In addition, all individual shareholders of an S Corp must be either U.S. citizens or permanent residents.
How Income is Allocated
The two structures differ in terms of how profits can be divided among the owners. An LLC gives you flexibility to decide how profits should be divvied up. But in an S Corp, income and loss are assigned to each shareholder strictly based on their pro-rata share of ownership.
Here’s an example: Let’s say you open a business with a colleague, each owning 50 percent. As the year goes on, your colleague gets busy elsewhere and you start taking on the bulk of the work. At the end of the year, the two of you decide that because you have done more work, you should keep 75 percent of the profits and your colleague gets 25 percent.
With an LLC, this type of agreement is fine. Owners simply need to agree to the arrangement and they will be taxed accordingly to their ‘operating agreement.’ By contrast, this type of flexible arrangement won’t work with an S Corporation. Because you and your colleague are each 50 percent owners, you each will be allocated 50 percent of the corporation’s income (at least when it comes to computing income tax).
Class of Stock
If you are concerned about the type of stock you can offer, take note that the two business structures are different. An S Corporation can have voting and non-voting shares, but cannot have distinctions like common stock and preferred stock. In an LLC, however, these priorities and preferences are allowed and you can have different membership classes.
When is the S Corporation Deadline?
If you’re interested in the S Corporation for your business, keep in mind that there’s an upcoming deadline to apply for S Corporation treatment. If you have an existing Corporation (C Corp) or LLC, March 15th is your deadline for filing IRS Form 2553 with the IRS and electing S Corporation status for this tax year and forward.
In other words, if your corporation/LLC existed on January 1 of this year, then you need to get your Form 2553 in by March 15, 2013 in order to have your S Corp in effect for the 2013 tax year. If you’re forming a new corporation this year, then your S Corporation deadline is 75 days from the date of incorporation.
The right business structure for you will ultimately depend on all the unique aspects of your business. But regardless of which business type you choose, taking a serious look at your legal structure is creating a strong foundation for your business.
S Corp Business Photo via Shutterstock
More in: Legal Structure