One of the most common questions asked when opening a new business is should I structure my business as an S corporation or an LLC?
Why do either? Can’t I just form a sole proprietorship and avoid all the headaches?
Opening a new business as a sole proprietorship is certainly the easiest form of organization. There are no state filing fees and no extra forms to file (sole proprietorship are filed on schedule C of an individual’s personal tax return).
The reason for filing your business as either and S corporation or an LLC is for the limited liability protection. In most business situations the owners of an S corp or an LLC are not personally liable for business debts and liabilities.
A single member LLC typically files a schedule C (the same form as would be used by a sole proprietor) while an LLC with 2 or more members will typically file a partnership return.
An S corporation will file a corporate return and both entities will have to file annual reports with the state.
Why are these entities known as pass-through?
A pass-through entity simply means that the organization itself does not pay income tax; instead it is passed through to its owners. If, for example, an LLC had taxable income of $100,000 this would be picked up by the member on his/her personal income tax return. Both S corporations and LLCs are pass-through entities.
What are the differences between the two entities?
There are generally more stringent rules regarding ownership of S corps than LLCs but neither has any major hurdles for most small businesses. S corps formed in New Jersey are subject to corporate minimum tax which ranges anywhere from $500 to $2,000 annually based on gross income.
Self employment tax is a tax imposed on income earned from a sole proprietorship, partnership or LLC that is the equivalent of Social Security and Medicare tax. Usually earnings of an LLC are subject to self employment tax (13.3% in 2012) while S corp earnings are not subject to self employment tax. Please keep in mind that as the owner of an S corporation you would be required to take a reasonable salary which would be taxed for Social Security and Medicare purposes.
S corps must make ratable distributions to all shareholders while LLCs can distribute to the members in any way they feel is appropriate.
Conclusion
This article just scratches the surface of the S corp vs. LLC question. While you now know the differences related to self employment tax, it is important to weigh all the differences such as an S corporation’s filing requirements, minimum corporate taxes and requirement to purchase workmen’s compensation insurance. LLCs also have the ability to elect to be taxed as an S corp, as always, I advise you to meet with a tax professional to help with this important decision.