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By Robert Steere, Toolkit Staff Writer
So you are ready to start a small business, eh? You have a wonderful vision for a unique new service or special product. Your business plan is a work of art. You are ready to cast off from the safety and security of your cubicle at the office and blaze a new trail of entrepreneurship. Congratulations!
Now, as you start, run and grow your new business, how do you intend to structure it so that it becomes an efficiently operating, thriving enterprise? Two of the most popular organizational forms today are the limited liability company (LLC) and the S corporation. But what if I told you that you could have the best of both worlds, so to speak, by establishing an LLC and then electing to be treated like an S corporation for tax purposes? Well, it can be done.
Business owners--even attorneys and accountants--often get twisted up in the debate over which is best, the LLC or the S corporation. But it's not necessarily an either/or proposition. Rather, you can set up an LLC and, after setting it up, you can elect to have the LLC treated as an S corporation. If your LLC operates an active trade or business, and payroll taxes (SECA taxes) on the owner or owners are high, you may find that an S corporation election is the best choice.
Both organizational forms share the characteristic of "passing-through" their income to the owner(s). Both also provide their owner(s) limited liability protection. But each has some distinguishing features, too. You, as a new business owner, will want to consider the differences as you choose the form for your enterprise.
Before choosing one of these options--or a combination of the two--determine the features that are most important to you and your business.
The Features of an LLC
An LLC is a business structure authorized by state statutes. It is a structure designed to provide the limited liability features of a corporation along with the tax efficiencies and operational flexibility of a sole-proprietorship or a general partnership. As a pass-through entity (unless it chooses tax treatment as a corporation), all of an LLC's profits and losses pass through the LLC to its owner(s), known as member(s). As with a proprietorship or partnership, each individual member reports the profits and losses on his or her federal tax return. This avoids the double taxation to which a regular corporation and its owners are subjected.
However, the LLC still provides a limit on the personal liability of its member(s) in much the same way a corporation does. Typically, a member's personal liability is limited to his or her investment in the LLC. This feature distinguishes the LLC from a sole proprietorship or general partnership, in which each owner is subject to liability for all of the debts of the business.
The features of an LLC may make it an excellent choice of structure for your new business enterprise. The following summarizes the most significant features of the LLC:
The IRS does not recognize the LLC as a taxpayer classification for federal tax purposes. For tax purposes, an LLC normally reports as a sole proprietorship or a partnership, depending on whether it is a single- or multi-member LLC. However, an LLC can elect to be treated as an association taxable as a corporation by filing Form 8832, Entity Classification Election. As an alternative, an LLC can file a Form 2553, Election by a Small Business Corporation, to elect tax treatment as an S corporation.
The Features of an S Corporation
An S Corporation is a corporation authorized by state 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 then 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.
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. Following are the main S corporation limitations:
A key feature 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 subject to FICA tax for Social Security and Medicare. Other net earnings that pass-through to the owners are considered passive income not subject to SECA tax. Thus, an S corporation can do some tax planning that can not be accomplished in a typical LLC.
The most important features of the S corporation include the following:
Combining the Benefits of the LLC and the S Corporation
If you think you can benefit from the combined features of an LLC and an S corporation, the surprising possibility exists to establish your business as an LLC, but then make the election to have it treated as an S corporation by the IRS for tax purposes. You'll have to make the special election with the IRS using Form 2553. It's no more difficult that setting up a corporation and then electing S corporation status. But it may have some added benefits. Let's take a look.
Obviously, you need to carefully consider the pros and cons of different forms of business organization. Be sure to consider how all the aspects--legal, tax and operational--of each organizational form will impact your unique business enterprise. Seeking professional advice from a CPA or tax attorney is always a wise practice when making choices like this that can affect your business for many years to come.
But setting up an LLC and then electing treatment as an S corporation may just give you the best of both worlds--the ease of administration of the LLC and the tax planning opportunities of the S corporation. Talk to your professional advisor today.