Small Business: S Corp or LLC?
June 21, 2013
If you are about to launch your own small business, or maybe even if you have been in business for a while, you may be considering your business structure. There are a lot of options, and all offer particular advantages and disadvantages.
If you’ve moved beyond the status of being a sole proprietor or maybe using a DBA designation, you might be thinking about the more complicated business structures, like an LLC or an S Corporation.
How do you choose between these two structures? What are the differences? And what will best suit your particular needs?
The California Franchise Tax Board has prepared a document, FTB 1123, which can help with this decision.
Formation of Entity – LLC
An LLC, or Limited Liability Company, is an entity that is formed to shield the owners, or members, from any individual liability. In this respect, the company is a completely separate entity from its owners, and no liability extends from the company to the members, or vice versa. This means that any debts or obligations of the company can be extended to the individuals, and no debts or obligations of the individuals can be extended to the company.
An LLC is an entity that is formed at the state level. It is formed by filing an “articles of organization” with the California Secretary of State.
Tax Consequences:
An LLC is taxed at the California state tax corporate rate of 8.84%, subject to a minimum tax of $800. An LLC files California Form 568, Limited Liability Company Return of Income, by the 15th of the 4th month following the entity’s tax year-end.
This fee is increased when the annual reported income of the LLC exceeds $250,000 annually.
The LLC does not pay taxes at the entity level, but instead the income is passed through to the owners, who then claim it on their personal income tax returns. The income and losses do not need to be split equally among members, but a written division of ownership must be established at formation.
The LLC must provide each owner with a K-1 which shows each owner’s share of the income and expenses of the entity for the tax-year.
The owners also must pay self-employment taxes on their income from the LLC, when they file their personal income tax returns.
The Business Entity Tax, also known as Franchise Tax, is a fee of $800 that is paid to the California FTB, due 75 days after entity formation and then once yearly after that.
Entity Formation – S Corporation
An S Corporation is formed by filing paperwork at the state level, and then by electing under federal law to be treated as a Subchapter S corporation.
This structure also shields owners from personal liability and affords the opportunity to pass income through to the owners with no federal tax at the entity level.
Tax Consequences
An S Corporation files California form 100S, California S Corporation Franchise or Income Tax Return. The return is due the 15th day of the 3rd month after the entity’s tax year-end.
The S corporation must provide each owner with a K-1 which shows each owner’s share of the income and expenses of the entity for the tax-year.
An S Corporation is taxed in California at a rate of 1.5% on the net income, although it is not taxed at the entity level for federal tax returns.
All of the income that is passed through to the owners is not subject to the self-employment tax. Self-employment tax is only assessed on what is considered a “reasonable salary,” which is one of the main benefits of forming an S Corporation versus an LLC.
Other S Corporation Requirements
S Corporations must also adhere to many of the requirements for larger corporations, which can make their maintenance quite cumbersome for a small business.
Owners must draft bylaws, hold annual meetings, issue stock, and other such bureaucratic paperwork that may or may not make sense for your business.
Conclusion
There are certainly other differences between the two legal structures, such as the number and type of owners that can participate in each type of entity.
If you are unsure, it makes sense to talk to someone who is an expert in the field. You can consult a business lawyer or a tax prep company that specializes in taxes for small businesses.
For more information on the topic watch this video.
