As an entrepreneur, one of the earliest and biggest decisions you’ll make is entity selection. This decision carries legal, financial, and tax consequences, making it one of the most critical decisions a business owner makes.
For-profit business entities can fall into two general categories: the partnership and the corporation. Partnerships include General Partnerships, Limited Liability Partnerships, and the Limited Liability Company (LLC). Corporations are mostly made up of C Corporations and S Corporations (or S Corp).
Because the LLC and the S Corporation are the most common business filings, we’ve sought out to compare the benefits, set up process, and requirements of the LLC and S Corporation to help business owners decide how to best organize your business.
For an overview of each entity type and a breakdown of tax returns filed by entity type, check out our Entity Glossary.
To jump start our review of the LLC vs S Corp, below we’ve provided the top three benefits for each below.
Top Three LLC Benefits:
- Asset protection
- Lower audit risk than a Sole Proprietor
- Less paperwork
Top Three S Corp Benefits:
- Asset protection
- Lower audit risk than a Sole Proprietor
- Provides savings on the Self Employment Tax, which can be huge
Ultimately, the entity selection depends on why it is important for you to be incorporated in the first place.
As you may determine from the information shared so far, the flexibility and simplicity of an LLC may work best if if you’re looking to get asset protection and are not concerned with minimizing the Self Employment Tax.
On the other hand, if you’re profitable and are determined to decrease your tax bill, limiting the Self Employment Tax with an S Corporation may be well worth the administrative cost.
While any entity selection must be made with your specific tax and legal needs in mind, we hope this information can spark some insights to help you decide if the LLC or S Corporation is good for your business. After all, it’s your business we’re talking about, not your advisor’s.
One final disclaimer: We wrote this article assuming the reader would find, read, and digest only what is important to his or her business. We do not expect you to read everything. This can be dry stuff for the non CPA or attorney. If you wish to read only one section, and one section only, check out our financial example comparing the LLC to the S Corporation structure below. We’ve also included a What This All Means summary at the bottom of this post.
How to Set Up an LLC
A limited liability company (LLC) is a business entity that provides asset protection and provides pass-through taxation treatment, meaning that the income from your business is “passed through” to your personal income at ordinary tax rates, and not separately taxed at the entity level. However, income from the LLC will be subject to Self Employment Tax (more on this below).
An LLC on its own is not recognized as a business entity for federal tax purposes. As a result, LLCs with multiple members typically file as a partnership on a separate tax return (see Form 1065). An LLC may also elect to be classified as an S Corporation for tax purposes, which provides the tax benefit of the S Corporation.
In a Single-Member LLC, the income “passes through” to the owner’s tax return on a Schedule C. That is one major advantage of the LLC since we can avoid the extra fees, time, and risk involved preparing a separate tax return. As a general rule for the lean entrepreneur: the less returns you can file, the better.
To set up an LLC for your business, you’ll need to:
- Choose a state. We advise incorporating in the state where you operate and live. If you are looking to take on funding by issuing stocks or if you are expecting to sell your business to a large competitor, then we may recommend Delaware.
- Choose a state: Deleware (cont’d). Delaware is popular for its strong case law and business-friendliness, but not as a way around state filing requirements or costs. You will still likely need to register your LLC in your state as a “Foreign LLC.”
Example: Coca Cola Subsidiary’s “Foreign LLC” Registration for California
- Choose an available business name and consider trademarks. The business name must comply with your state’s rules regarding LLCs and must be unique. As a general rule for LLCs, you cannot use “Inc.,” “Corp,”, “Corporation,” “LLP,” or “Partnership” in your company name, since these terms are reserved for Corporations and Partnerships. To confirm your business name is unique, check your state’s searchable business directory. You may also want to do a trademark search with the U.S. Patent and Trademark Office (USPTO) to confirm the name is not trademarked within your industry. If you want to buy a trademark or copyright, be ready to spend some dough to hire an attorney as you don’t want to get this wrong. The agencies involved require filing fees range from $100 to $600 and the attorney will charge between $800 to $1,500.
- File the required registration with the state. Some states (including Delaware, Mississippi, New Hampshire, New Jersey and Washington) call this document a “certificate of formation.” Two other states (Massachusetts and Pennsylvania) refer to this document as a “certificate of organization.” Simply Google “Register LLC” and your state’s name, and look for the state’s site with URL’s ending in “.gov” to go straight to the source (each state will have its own process explained online). We’ve listed examples of state government sites where you can register your LLC, all within 30 minutes.
- Create an LLC operating agreement, also commonly referred to as the articles of organization, which should not be confused with the state registration above. This agreement will formalize the percentage interests in the business, voting power, rights and responsibilities of each of the members of your LLC. You can find free services or relatively cheap “DIY” providers online who will give you templates for operating agreements. However, we recommend checking with an attorney to get specialized advice — especially if this is your first LLC or if you’re setting up a partnership or protecting and/or dealing with valuable assets. Consider this as a part of your education expense, which is also tax deductible.
In addition, some states such as Arizona and New York require that you publish a notice of your intent to form an LLC. The majority of states do not have this requirement.
Once your LLC is filed with the state, you’ll likely need to file an annual statement of information. For tax purposes, a SMLLC can forego filing a separate federal tax return. At the state level, however, LLC’s may need to file a state tax return. With regards to taxation of the LLC, distributions are subject to the Self Employment Tax of 15.3%.
State Regulations for LLC’s
You will also need to check with the state(s) in which your business will operate for specific filing and license requirements. Certain states require specific annual or quarterly tax filings or require minimum payments for operating in their state. For example, states such as California, Texas, and Missouri each require a minimum “Franchise” tax for doing business in the state, which can be up to $800 per year even if there is no income.
Your state may require you to file annual information reports and may require you to obtain additional permits and licenses before you start conducting business. Many states require eCommerce businesses to get sellers permits to sell into the state. Do not do this prematurely as the state will likely ask you for sales tax as soon as you file, even if you don’t have any sales yet.
The Benefits of an LLC
Ultimately, LLCs offer benefits over sole proprietorships and certain benefits when compared to corporations, when it comes to the following factors:
Paperwork (less). In comparison to corporations, LLCs are considered to be more flexible, given that there’s less paperwork and less stringent requirements for compliance. That means that it is easier to form an LLC and keep it in good legal standing.
Asset protection. Like corporations, LLCs offer liability protection, which means that you will not be held personally liable for the debts and court judgments incurred by your LLC. Creditors are not permitted to go after the personal assets of the LLCs members.
Lower audit risk. By the numbers, compared to a Sole Proprietor, LLC’s are audited far less likely to be audited than a Sole Proprietorship, which are audited highly. Because so many Sole Proprietors file taxes relative to business entities, and because entities typically receive more professional assistance with record keeping and tax filings, the IRS dedicates more resources to catching typical mistakes made on the Schedule C.
This is the first of a two-part series comparing the LLC and S Corporation, focused on the LLC. For the next segment, check our post on the S Corporation.
Please note: This blog is for informational purposes only. Be advised that business taxation rules and laws are subject to change at any time. For specific tax advice regarding your business, contact us.