Most businesses begin as a sole proprietorship because it’s easier to start and requires less paperwork and regulatory overhead. It generally costs less than filing as a Limited Liability Company (LLC) or Incorporation (INC).
However, each of these legal statuses has certain tax strategy advantages, so it’s important to carefully consider which status is:
- 1️⃣ The best legal structure for your business goals.
- 2️⃣ The most tax beneficial, keeping more money in your pocket annually.
💡 The Tax Advantage of S Corporations
For those choosing either the LLC or INC entity, S-Corp status allows the business to use “pass-through taxation” (i.e., business income goes directly to owners instead of the corporation). This allows the business and owner to potentially save money, avoiding the payroll taxes on LLC profits or the double taxation faced by INCs when distributing money.
📌 Brief Overview of an INC Structure
Protection from Liabilities
INC (Incorporated) status offers business owners (i.e., shareholders) the strongest protection from business liabilities, as it is a separate legal entity from the owners and shareholders.
Shares and Shareholders
With an INC, the business can also sell shares of stock and offer employees a stock option plan. INCs may have any number of shareholders. Note that most public companies you may hold shares of stock in are generally structured as an INC too.
C-Corp and Double-Taxation
Keep in mind that when setting up an INC, the IRS automatically treats the entity as a C-Corp, where all profits and losses flow to the corporation. Taxes are paid at C-Corp rates, and the only way to extract money for a shareholder/business owner is through dividends or W2 salary. This setup results in “double taxation”—first at the corporate level and again at the individual level on dividends and salaries. Electing S-Corp status allows you to avoid this by paying payroll taxes only on a reasonable W2 salary, with the rest taxed at your individual effective tax rate.
📌 Brief Overview of an LLC Structure
Brief Overview of an LLC Structure
Flexible Business Structure
A Limited Liability Company (LLC) is the most common alternative to the INC. The business structure of an LLC is more flexible than an INC, easier to maintain without the required annual meetings and minutes, and still provides a good deal of protection from legal liability, as long as the owner maintains a clear corporate veil by separating business and personal finances.
Less Paperwork and Administration
LLCs require less paperwork to form than S Corps. For one thing, there is no board of directors. The LLC’s owners just file the Articles of Organization for the LLC with the state agency. LLCs are then required to get an EIN from the IRS and maintain the necessary licenses and permits, just like INCs.
Tax Election Choices
An LLC has one class of shareholders/members and can choose how it will be taxed—Sole Proprietorship (SchC) filing, Partnership, S-Corp, or C-Corp. The tax election depends on your business and its needs. LLCs are generally classified as pass-through entities, with any profits and losses passing through to the members and reported on their personal tax returns unless they opt for C-Corp taxation.
❓ How Can Electing S Corp Status with the IRS Benefit Me?
S Corp Election Does Not Change the Business Legal Structure
Becoming an S-Corp is done strictly for tax purposes. A business stays the same legal structure of an INC or LLC, but by electing S-Corp status, the business can have its profits and losses pass through to individual tax returns, potentially saving on taxes.
Minimizing Payroll Taxes with S-Corp Status
The main reason for choosing to elect S-Corp tax status is to avoid paying payroll taxes on all of your profits and avoid double taxation. Instead, an S-Corp election allows business owners to pay themselves a “reasonable” salary, with payroll taxes only on that portion. This can be determined by taking an S Corp Compensation Test to figure out what the “reasonable” salary should be.
Is Electing S Corp Status the Right Choice for My Business?
S-Corp Is Not Ideal For Everyone
While all S-Corp profits and losses are passed through to an individual 1040, making the S-Corp election is not necessarily beneficial for all businesses. Startups looking to take on equity investment, businesses offering equity compensation, or partnerships splitting profits and equity interests are examples where an S-Corp election may not be the right choice.
Maintaining S-Corporation Tax Election
To maintain an S-Corp tax election, the business must be a U.S. LLC or INC with only one class of stock and fewer than 100 shareholders. All shareholders must be individuals, estates, or specifically qualified trusts. Each shareholder must consent in writing to the S-Corporation election, and each must be a U.S. Citizen or permanent resident alien with a U.S. Social Security number.
S Corp Must Have a December 31st Year-End
The tax year for an S-Corp must end on December 31st.
Changing Tax Election with the IRS
You can always update your tax election with the IRS at any time. There may be tax consequences for doing so, but it’s possible by a majority shareholder vote. Note that with the 199A (Qualified Business Income Deduction) deduction, electing S-Corp status could further maximize your tax savings depending on your industry.
Need Help?
We have been helping small business owners identify their business entities for over a decade. Plus, we advise on how to best set up your entity to maximize your tax benefits. Contact us today to start saving on your business and individual taxes tomorrow.