One of the most important questions to ask when forming a small business is, "Which entity is right for my business?". The answer is that it depends. However, limited liability companies (LLCs) and S corporation structures are the most popular choices. Based on your business goals, one is likely more advantageous than the other.
Whichever structure option you decide on, it's recommended that you consult an LLC lawyer for guidance.
Understanding LLCs: What They Are and How They Work
A limited liability company is a business structure that protects the personal assets of business owners and investors from liability arising during business operations. In other words, business liability typically won't transfer to the LLC's owners and investors.
The LLC designation is a more flexible option than a corporation in terms of profit distribution and business structuring, which works well for small business owners. Companies formed under LLC rules can have one or more owners, who are known as members.
Understanding S Corps: What They Are and How They Work
An S corporation is not a business structure but a tax classification used primarily to avoid double taxation. Double taxation occurs when business profits are taxed at the business level and then again on the individual tax returns of company owners and investors.
Businesses also choose S corporation status because of the asset protection it affords. As with LLCs, S corporations also provide limited liability.
With S corporation designation, a business will be taxed using pass-through taxation, which sees owners and investors pay taxes on their shares of the company's profit on their respective tax returns.
To be eligible to form an S corp, a business must:
- Be a corporation that was formed domestically;
- Have no more than 100 eligible shareholders;
- Have no more than one class of stock;
- Be an eligible corporation.
Additionally, S corporations must have individuals as shareholders. Partnerships and corporations cannot be shareholders of S corporations.
Comparing S Corps and LLCs: Understanding the Differences
The main difference between LLCs and S corporations is that an LLC is a type of business entity, whereas an S corporation is a tax classification. As such, it's entirely possible and common for an LLC to opt for S corporation tax status.
Owner Employment Options for LLCs and S Corps
When it comes to employment options, both S corporations and LLCs give businesses the option of putting owners and investors on the payroll and paying them a salary.
However, this isn't mandatory. Owners and investors have the option of remaining completely hands-off, receiving zero salaries, and declining to participate in the management of the business.
Ownership Structure in LLCs and S Corps
The rules governing the ownership structure of LLCs are far more flexible than those controlling S corp ownership.
LLCs can have unlimited members from across the globe, whereas S corps owners must be U.S. citizens, and the corporation itself must be a U.S.-based business. Additionally, S corps must have no more than 100 owners.
Management Structure Comparison: LLCs vs. S Corps
The activities of corporations are overseen by boards of directors, who are responsible for guiding the company's operations through high-level decision-making. The board is elected by shareholders, and various officers, such as the president, secretary, and treasurer, exist to manage the day-to-day business dealings of the company.
By contrast, LLCs don't have boards of directors but managers. LLCs may, however, decide to elect or appoint officers if doing so makes sense in the context of their business dealings.
Stock and Shareholders in S Corps and LLCs
LLCs don't have stock or shareholders but members, who are paid according to the terms outlined in the articles of organization. S corporations, on the other hand, have stocks and shareholders. However, an S corporation may only issue one class of stock.
Tax Liability and Reporting Requirements for LLCs and S Corps
LLCs can choose to be taxed as S corporations if they meet the eligibility requirements.
Without the S corporation designation status, LLC owners are responsible for a self-employment tax of 15.3% on net profits. With an S corp designation, business owners have less-strict tax and tax filing obligations than those businesses using the C corporation status designation.
This means that businesses that elect S corporation status aren't responsible for quarterly taxes and aren't subject to corporate income tax. Their owners take a salary directly from the S corporation and pay taxes on their profits on their tax returns.
Establishment Cost Comparison: LLCs vs. S Corps
The basic costs for establishing an LLC and an S corporation in New York vary depending on many factors. The costs will be lower for those who choose to handle every aspect of the establishment process. However, the expenses businesses pay lawyers and professionals to help them get established are usually well worth it.
Generally speaking, the costs you may be looking at when forming an LLC or S corporation include:
- Naming costs;
- Articles filing cost;
- Registered agent costs;
- Operating agreement costs;
- Business name publishing costs.
Under no circumstances is it a good idea to skimp on the establishment stage of your business. The repercussions of errors during this start-up phase of your business can be devastating to the long-term health of your company.
Tax Differences Between LLCs and S Corps in New York
When deciding whether to use an LLC or S corporation, it's important to understand the difference in the tax treatment each receives at the state and federal levels.
Without any elections whatsoever, the IRS and the New York Department of Taxation and Finance subject corporations to double taxation. That means the corporation will pay a corporate income tax on its income, and shareholders will also pay taxes on the distributions they receive.
However, LLCs and S corporations are pass-through entities, meaning income passes through the business untaxed and is only subject to taxation when members or owners file their personal income tax returns. It is for the distinct advantage of avoiding double taxation that many businesses seek S corp status.
Federal Tax Implications for LLCs and S Corps
An LLC that doesn't choose S corporation status avoids double taxation. However, when LLC members receive their business income and report it on their income taxes, they must pay a self-employment tax of 15.3%.
That said, this 15.3% self-employment tax can be avoided by opting for S corporation status. By doing so, the owners of the LLC receive a salary upon which they pay state and federal taxes.
If these owners make income additional to their official salary, the money is treated as a distribution instead of a wage. Although the distribution is also subject to a tax, the tax rate is less than that for income.
New York State Tax Implications for LLCs and S Corps
Most LLCs interested in taking advantage of S corporation taxation must complete a specific New York S election in addition to the election filed with the IRS.
However, New York automatically applies the S corp election if an IRS-designated S corp has an investment income of more than 50% of its gross income. This automatic application of S corp status is known as the mandated New York S corporation election rule.
Additionally, all S corporations and LLCs that choose C or S corporation status (as well as C corporations) in New York State are responsible for paying an annual franchise tax fee while active in the state.
Comparing Franchise Tax Rates for LLCs and S Corps
The tax rates for LLCs vs. S corps can vary, depending on the revenue a business generates.
- LLC with Partnership Tax Treatment: LLCs taxed as partnerships are only responsible for filing fees, which are calculated based on gross income. For LLCs generating less than $100,000 in gross income annually, the filing fee is $25. Businesses making over $25,000,000 have a filing fee of $4,500;
- S Corporation: The franchise tax rates for S corporations are only slightly lower than those for traditional corporations. The S corporation's gross receipts are used to determine the amount due.
Keep in mind that if an LLC decides not to elect S corporation status, it won't be subject to a franchise tax on its income. However, upon electing S corporation status, the LLC must pay a franchise tax calculated using its gross receipts.
LLC vs. S Corp: Choosing the Best Entity for Your New York Business
Every business is unique. Some operations may benefit greatly from adopting an LLC or an S corporation status, while others may be barred from one or both. Examining your business needs closely will help you determine which option is best for you.
When making this decision, ask yourself the following questions:
- How many stakeholders are there?
- Is everyone a U.S. citizen?
- Are there partnerships or corporations as stakeholders in the business?
- What effect would a self-employment tax have on our net profit?
The answers to these questions will help you reach the right decision as to which designation to choose.
When an S Corp Might Be the Best Fit for Your Business
Various factors make the S corporation designation a good option for a business.
First, taxes levied against S corporations are typically lower than those levied against LLCs. S corporations don't pay self-employment taxes, but LLCs do (unless they choose S corporation status). This means that the only tax paid on business earnings occurs at the personal income tax level.
Another factor making S corporation status desirable is if your company's organization features numerous individuals tasked with running the business. A board can provide the necessary oversight to keep the company running smoothly.
You may also prefer to receive a steady paycheck, as a W-2 employee of your business. The caveat is you must be bringing in enough income to cover a “minimum reasonable salary” for your position and responsibilities.
When an LLC Might Be the Best Fit for Your Business
LLCs are ideal for those who want to enjoy limited personal liability and engage in as little business upkeep as possible.
LLCs have far fewer reporting and filing requirements than other business organizations. Additionally, the New York LLC designation doesn't preclude a business from electing S corp status, which allows them to avoid the hefty 15.3% self-employment tax on business profit.
Obtain Professional Assistance from Lawyer For Business
If you're trying to decide between an S corp vs. LLC New York, it's important to know that each may have distinct advantages and disadvantages depending on the unique needs of your business.
For example, LLCs offer greater flexibility than S corporations all around and have less strict formation and reporting requirements. That said, S corporations are much more advantageous in the realm of tax savings.
Because of the diversity of small businesses, there's no one-size-fits-all choice. Instead, each business decides which to choose according to its needs and objectives.
At the end of the day, working with an experienced business lawyer is the best way to ensure that you choose the right option.
At Lawyer For Business, Andrea A. Willis has worked with numerous clients throughout New York State needing to effectively structure their businesses for the future. Contact us today for a free consultation.
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