LLC or S Corporation? How to Think About Entity Selection
“Should I be an LLC or an S corporation?” is one of the questions we hear most. It is also a question built on a misunderstanding, because the two are not alternatives.
An LLC is a legal structure created under state law. An S corporation is a federal tax election. An LLC can keep its legal structure and elect to be taxed as an S corporation. So the real question is: how should my business be taxed?
How an LLC is taxed by default
A single-member LLC is taxed as a sole proprietorship: the profit is reported on the owner’s personal return. A multi-member LLC is taxed as a partnership and files its own informational return.
In both cases, the owner’s share of the profit is generally subject to income tax and to self-employment tax, whether or not the money was taken out of the business.
What changes with an S corporation election
With the election, an owner who works in the business becomes an employee of it. The business must pay that owner a reasonable salary through payroll, with the corresponding payroll taxes. The remaining profit passes through to the owner and is not subject to self-employment tax.
That difference is where the potential benefit comes from. It also comes with responsibilities:
Running payroll and filing payroll tax returns on time.
Filing a separate business return (Form 1120-S), due March 15 for calendar-year businesses.
Keeping accurate, current books throughout the year.
Paying yourself a salary that is reasonable for the work you perform.
When it is worth evaluating
There is no single profit number that makes the election right for everyone. It tends to be worth a careful look when:
Your profit is consistent and comfortably above what a reasonable salary for your role would be.
Your books are current and reliable.
You are ready to run payroll, including for yourself.
It may be early if your income is still irregular, your business is in its first months, or your bookkeeping is behind. In those cases, the added cost and administration can outweigh the benefit.
Eligibility and timing
Not every business qualifies. Among other requirements, an S corporation can have no more than 100 shareholders, only one class of stock and no nonresident alien shareholders.
The election is made on Form 2553. It must be filed no more than 2 months and 15 days after the beginning of the tax year in which it takes effect, or at any time during the preceding tax year. For a calendar-year business, that generally means by March 15. Relief for late elections is available in some situations.
Questions to bring to the conversation
What was your profit over the last 12 months?
How do you pay yourself today?
Are your books reconciled through last month?
Do you plan to hire in the next year?
Entity selection is not a one-time decision. The structure that fit your business in its first year may not be the right one today. Whether you are forming a new LLC or reviewing an existing one as part of your tax planning, a review with current numbers turns a confusing question into a clear decision.
Start With a Business Review. Schedule a consultation and we will look at your numbers together.
This article provides general information and is not tax or legal advice for your specific situation.
