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Choosing to Organize Your Business as an LLC or S Corp: Part 3

Posted by Alfred Fricano Posted on Nov 05 2016

By Alfred Fricano

Congrats! You’ve started your own business. With any new venture there is usually mountains of paperwork and important business decisions that need to be made. four-part blog series is focused on one of those decisions: choosing to organize as an LLC, an S Corp or a combination of both. Each has its advantages and pitfalls. If you missed Part 1 and Part 2 you can read them here.

In Part 3, we discuss the pros and cons of operating as an S Corp, including what an S Corp is, its most important features and the benefits of being one.

What is an S Corp?

An S Corporation is a corporation formed by complying with state incorporation statutes that then elects (by submitting Form 2553 to the IRS) to pass corporate income, losses, deductions and credits through to its owners (shareholders) for federal tax purposes.

S corporation owners report the income and losses on their personal tax returns and are assessed tax at their individual income tax rates. Thus, S corporations avoid double taxation on the corporate income.

Limitations on S Corps

Certain limitations are placed on a corporation that seeks treatment as an S corporation. But if these limits don't interfere with your business plans, the S corporation may be a good choice for you. The main S corporation limitations include:

• It must be a U.S. corporation.

• It must have no more than 100 shareholders. However, all members of a family are counted as a single shareholder. Spouses are also counted as a single shareholder.

• Its shareholders can only be individuals, certain trusts, and estates - they may not be partnerships, corporations or non-resident aliens.

• It can have only one class of stock. But, it can have voting and non-voting stock within that single class of stock.

• Certain financial institutions, insurance companies, and domestic international sales corporations are ineligible.

Advantages of S Corps

A key benefit of the S corporation is its ability to minimize overall tax liability for you and your business. Because of its nature as a corporation, only the wages paid to its owner/employees are earned income that is subject to FICA tax (Social Security and Medicare).

Other net earnings that pass-through to the owners are considered dividend income. This means those payments not subject to SECA tax and — provided the shareholder material participates in the business — they are not considered passive income. Thus, an S corporation can do some tax planning that cannot be accomplished in a typical LLC.

How much should you pay yourself?

The ability to split income between compensation and dividends became even more important in 2013 when two new Medicare taxes were imposed on higher-income taxpayers. One was a 0.9 percent surtax on all compensation over $200,000 ($250,000 for married filing jointly).

The other was a new 3.8 percent tax on investment (passive) income if the taxpayer's modified adjusted gross income exceeds $200,000 ($250,000 for married filing jointly). Thus, the ability to split income can aid in reducing exposure to these new taxes.

Of course, the compensation that you pay yourself must be reasonable not too low or too high -if you want the arrangement to stand up to IRS scrutiny.

Reasonable compensation turns on many factors, but can be summed up by a "yes" answer to the question: "Is the compensation what would be expected for an individual with the background and qualifications in other companies of this size in this industry? 

More features of S Corps

In summary, the most important features of the S corporation include:

• Limited liability for owners

• Pass-through of income to owners, avoiding double taxation

• The business exists independent and separate from the owner/shareholders

• Complex administrative operation - more forms and filings required, more formal meetings and record keeping requirements imposed (bylaws, meeting minutes, written resolutions, etc.)

• Profit-sharing restrictions - earnings distributed proportionate to capital contributions of shareholders

• Flexibility in distributing earnings of the corporation by paying wages and salaries to owner/employees and passing-through other net earnings as passive income to owners

Hire a professional accountant

When starting a business, deciding to organize as an S Corp or LLC can have a major impact on your tax responsibilities and liability. It’s not a decision to attempt to make on your own or take lightly. Seeking the counsel of a professional tax accountant can save you money and legal trouble down the road.

In Part 4 of this series, we’ll discuss the advantages and disadvantages of organizing in a way that takes the benefits of both an LLC and an S Corporation.