Choosing the right entity may seem like a difficult task. And it certainly can be! Any number of considerations can influence this decision. From the tax structure to the number of owners, there are many things to consider as you try to determine which entity choice is right for you.
One of the main three options is the S-corporation. The IRS provides a fairly succinct definition of what it means to be an S-corporation. According to the IRS, it is a corporation with an “S” election in place. What this means is that the corporation has elected under the IRS Code to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. The result is that S-corporation shareholders report the flow-through of income and losses on their personal tax returns, thus avoiding the double taxation issue of the C-corporation model.
This may sound pretty similar to the way an LLC is taxed. It should; while there are some differences in certain circumstances, both the LLC and the S-corporation generally employ the flow-through method described above. One big difference is in terms of a “reasonable salary.” This comes into play in the context of self-employment tax. Both LLC and S-corporation owners will have to pay self-employment taxes, but the difference is that, with an S-corporation, such tax is limited to the salary you pay yourself as an owner-employee. A NOTE OF CAUTION, fudging the numbers on your salary is a good way to get audited.
If you’re thinking the S-corporation structure may work for you, it is key to consider a couple differences between the S-corporation and the LLC. Obviously, there is the question of taxes. Depending on your intended business model, one or the other may work better for you. Then, there is the way profits and losses are allocated. With an LLC, profits and losses may be allocated among the members as they see fit; with an S-corporation, they must be in accordance with ownership percentages. And there is the flexibility that the LLC offers you, with far fewer rigid formalities than the corporate model.
Of course, you could form an LLC and elect to be taxed as an S-corporation by filing the appropriate tax election with the IRS. This can be an attractive model, combining the benefits of the LLC with the tax scenario of the S-corporation. In choosing entity choice, however, it is wise to consult your CPA and attorney because, although it may seem a simple choice, there are definite complexities that could use the benefit of a practiced hand. CPAs and/or tax attorneys should be consulted prior to selection of entity and in regards to other tax questions.
Lastly, as you consider entity choice, it is important to remember what the IRS says about qualifying for S-corporation status: certain requirements must be met. These include the following:
- It must be a domestic corporation;
- It must have only allowable shareholders, which include individuals, certain trusts, and estates and may not include partnerships, corporations or non-resident alien shareholders;
- It must not have more than 100 shareholders;
- It must have only one class of stock; and
- It must not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
If you are unsure of what business entity is right for you, give us a call at 919-900-4720 or visit our Contact Us page to discuss your situation with one of our business planning attorneys.