When forming a new business, it’s important to make the right decision for personal liability as well as minimizing the company’s tax liability. An S Corporation is one option that allows for limited personal liability as well as certain tax advantages. An LLC and an S Corporation have some similarities, yet the differences can amount to a substantial advantage depending on the business structure.
What is a Subchapter S Corporation?
An S Corp. is a special tax provision for a corporation that’s recognized by the Internal Revenue Service. The main advantage is that it allows taxable income to be passed to the individual shareholders. This helps to reduce the burden of double taxation. Instead of the corporation paying income taxes on profit at a higher percentage, the tax liability is passed to shareholders at a lower personal income tax rate.
In order to file for S Corporation status, the company must have fewer than 100 shareholders. The shareholders must agree to the filing and the election reported on IRS Form 2553. A husband and wife for example, along with other family members that are the sole shareholders can file for S Corporation status, as long as all the other rules are meet.
What is a Limited Liability Company?
An LLC is a business entity that is formed under state law. Some regulations can differ by state but the basic rules are similar from state to state. An LLC is similar to a corporation when it comes to personal liability of the company’s owner(s). Where income tax liability is concerned, an LLC can be treated more like a sole proprietorship or partnership.
For a small business, where there is a sole proprietorship or partnership, forming an LLC maybe a more attractive option than an S Corporation. A limited liability company affords the same type of business tax advantages but the filing is much less complicated. With an S Corporation the shareholders must agree to the filing. With an LLC, the members or owner(s) must agree to the formation. For a sole proprietorship that’s only one member.
Tax Advantage Example – LLC and S Corporation
In the following example the type of business model is a small partnership and is more geared towards an LLC. The net profit (before taxes) for the company for the year is $200,000. There are two members of the LLC, member A is a 60% owner and member B has a 40% ownership share.
Under a standard corporation, the $200,000 profit could be subject to a 40% corporate income tax liability. With an LLC, the company profits would be realized as personal income. The members file a standard personal 1040 Form and Schedule C, Profit and Loss Form Business. Other IRS forms also apply for the purposes of an LLC.
LLC Tax Example
- Member A adjusted gross personal income $120,000
- Member B adjusted gross personal income $80,000
- Member A effective federal tax rate after personal deductions 17%
- Member B effective federal tax rate after personal deductions 12%
- Member A tax liability $20,400 (17% of $120,000)
- Member B tax liability $9,600 (12% of $80,000)
- Total income tax liability for LLC = $30,000
Standard corporation federal income tax liability on $200,000 net profit would be $80,000 (40% of $200,000). It’s important to realize that when proprietors of a business draw compensation, that their compensation is deducted from net income. This example is exaggerated to make a point of the difference in standard corporate tax versus an LLC and S Corporation tax liability.
Different tax rules may also apply by state. Before electing a particular business entity classification, the advantages and disadvantages should be carefully weight. State laws should also be a consideration. It’s advisable to seek the advise of a tax attorney or accountant before a decision is made.
Source:
irs.gov
James Clausen - Clausen received a Bachelors Degree in Business Administration in Automotive Management and Marketing at Northwood University, graduating ...
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