S Corporation or LLC: What Is the Best Pass-Through Entity for You?

What Is Pass-Through Tax?

Pass-through tax means the owners of a company pay taxes while the entity itself does not pay taxes. The owners claim the income of the company on their personal tax returns. In general, this type of taxation applies to partnerships, S corporations, limited liability companies (LLCs), and sole proprietorships.

Benefits of Pass-Through Entities over C Corporations

One of the primary reasons a company would choose an LLC or S corporation over a C corporation is taxation. C corporations are taxed at the business level and the owners of the company pay additional taxes on the income they draw from the business. Expenses are claimed only by the company, unlike an LLC or S corporation where the owners can claim the expenses of the company on their personal taxes.

LLC vs. S Corporation

Before deciding which pass-through entity is best for your needs, it is important to understand the similarities and differences between an LLC and an S corporation.

Establishing an LLC or an S Corporation

To establish an S corporation, the owners must create articles of incorporation and then file Form 2553 with the IRS. Going forward, the owners will claim the income from the S corporation on their personal taxes. Business owners should check with their respective Secretary of State to determine which state-level forms must be filed as well as to obtain the required business permits and licenses.

Forming an LLC is a bit more complex. Owners must check with the entity in the state that handles LLCs—in most cases the Secretary of State—to ensure they do not duplicate the name of an existing LLC. Depending on the state in which your business is registered, you will have to file an LLC certificate of formation, articles of organization, or a certificate of organization. Once this is complete, an LLC operating agreement must be drafted which details the business's operation and ownership. Like with an S corporation, the necessary permits and licenses must then be obtained.

Ongoing Reporting Requirements

For most LLCs, an annual report is required by the state. Outside of this, there are no other formal requirements outside of the potential requirement of a franchise tax in some states. Some LLCs may wish to review their operating agreement or take time to update their membership list.

For S corporations, formal annual meetings must be held and meeting minutes must be recorded. Additionally, any transfer of stocks must be properly recorded and reported. Some states may have additional requirements including updated financial records which may have to be recorded with the Secretary of State. Franchise taxes may also be required.

Tax Requirements for LLCs

While an LLC is not directly responsible for paying income taxes, the owners must still file the appropriate forms with the IRS. Form 1065 must be filed to show the total income of the LLC if there is more than one owner. Members of the LLC will need to be issued a Schedule K to show their portion of the income. If there is only one owner, they may simply claim the income on their personal return.

Tax Requirements for S Corporations

Those who elect for an S corporation designation must file Form 1120S with the IRS on an annual basis. This form is where the owners will detail the appropriate deductions, expenses, etc. of the business. Accompanying this form is Schedule B, which includes other information such as listing any stock the S corporation owns in other companies, including corporations and partnerships. The S corporation will then issue Schedule K-1 to each shareholder. It is worth noting that all owners of an S corporation are entitled to receive a salary; quarterly taxes are typically filed for the S corporation using quarterly employer tax returns.

Accepting Investors in LLCs and S Corporations

An LLC that is seeking investors may run into numerous problems due to the business structure they have selected. However, there are fewer restrictions on LLCs, including the ability to seek investments from non-U.S. citizens as well as other businesses. One concern for owners is not running afoul of state and federal securities law. In nearly all cases, if you are considering investors from outside the original group of people who invested in the LLC, it is imperative to contact an attorney who understands securities law. LLCs can offer multiple shares of stock which may help them attract new investors.

For S corporations, there are numerous restrictions. One restriction is the company may issue only one class of stock. Additionally, there may be no more than 100 investors and the types of investors are limited. U.S. citizens as well as some estates and trusts may invest in this type of business; however, investors in an S corporation must not include other corporations, partnerships, or non-U.S. citizens.

Changing Ownership

LLC ownership is laid out in the original operating agreement. In nearly all cases, this agreement will have a buy-sell clause that explains how adding members, or dropping members, will proceed. In the event an LLC does not have a buy-sell clause, members will need to check their state statutes before changing the owners to determine if they can add new members by adding a buy-sell clause to their operating agreement. If state statutes prohibit these changes, the members may opt to create a new LLC.

Before changing the ownership structure of an S corporation, one must first be certain the new owner is qualified to be a participant in an S corporation. This hurdle can be overcome by ensuring the original documents, such as corporate bylaws, prohibit owners from the restricted class. To transfer ownership of an S corporation, the following steps need to be considered:

• Valuing shares – Before transferring ownership, the shares of the company must have a dollar value assigned to them. This will involve deciding what the company is worth and how many shares are currently outstanding. This can be a complicated process since S corporations are closely-held and assigning value is complicated. A financial professional may be needed to assist with this step.
• Draft a sales agreement – Preparing an agreement for the new owner can be complicated and will require the assistance of legal counsel. This may involve an outright purchase of a specific number of shares in one block or may involve purchasing shares over time if the company is being purchased in total.
• Tax implications of share selling – If one owner is being completely bought out in one lump-sum payment, they must be provided a final Schedule K-1. It is a good idea to consult with a tax professional to ensure the tax ramifications of this type of transfer will not be burdensome to the individuals involved in the transfer.

Ownership in a Limited Liability Company

An LLC may be fully owned by only one person. This structure allows one person to dictate the general direction of the company as well as the day-to-day operations of the company. However, there are other possibilities for ownership including groups and other companies such as other LLCs and corporations. The restrictions on ownership are typically dictated by the operating agreement.

There are no statutes that prohibit an owner that is not a U.S. resident from participating in an LLC. However, depending on the state where the LLC is formed, there may be other restrictions. For example, the state may mandate that an LLC for a physician's practice only be owned by licensed physicians. Before starting an LLC, you should be aware of the state-specific restrictions on ownership.

Ownership in an S Corporation

There are specific companies that do not qualify for S corporation status, including those who participate in financial services, sell insurance, or are primarily focused on international sales. In addition to the limitations on what types of companies qualify for S corporation status, there are restrictions on the number of shareholders and the qualifications to be a shareholder.

Firstly, S corporations are only allowed to have 100 shareholders in total. None of these shareholders may be non-resident aliens, corporations, or partnerships. Secondly, along with U.S. residents, there are specific trusts and estates that may be eligible shareholders provided the maximum number of shareholders is not exceeded.

Employee vs. Self-Employed

When an LLC pays a member for services, the wages are considered wages from self-employment and are reported on Form 1099. There is no requirement that members of an LLC be paid a wage. If the LLC employs staff members, they may be paid a wage and are therefore considered an employee. In this case, the LLC would be responsible for employee taxes.

S corporations are different in that shareholders who perform a service are entitled to be paid a wage. If the services performed are considered minor, they need not be considered employees. However, in the case where no services are performed or the services are considered minor, the shareholder would be considered self-employed. It is a good idea to speak with a tax professional about how to treat shareholders of an S corporation to ensure all tax requirements are fully met, including quarterly payments to Social Security and Medicaid as well as withholding taxes when required.

Conclusion

When you first sit down to draft your business plan, it is important to understand what your long-term goals are in terms of seeking investment, protecting your personal assets, and minimizing your tax liabilities. There are numerous decisions that must be made early in the planning process, including which business structure is right for you and your business.

For most entrepreneurs, seeking legal advice before deciding on a business structure is a good idea. State-level restrictions may also impact your final decision on your corporate structure. Ensuring all corporate documents, including bylaws, operating agreements, and business permits, are all prepared and properly filed can prevent problems later. In nearly all cases, getting the best legal advice prior to deciding on a business structure is a necessity. Starting a business is exciting, and getting started on the right foot can help ensure your business's long-term survival and success. Click here to create your business formation documents now.