“I’m trying to decide between an LLC and an S-Corp.” said a riding instructor I talked to recently. She’s making the transition from freelancing to having her own school, and the mother of a student had emphasized the importance of “having the right structure”. Until she could figure out what was ‘right’, her plans were on hold.
Unfortunately, she had fallen victim to a very common confusion. LLC is a legal structure. S-Corp is a tax structure. It’s like asking if you want a Quarter Horse or a mare.
In Part One (link) we looked at various legal structures. Now we’ll consider common tax structure options.
TAX STRUCTURES FOR BUSINESS
Sole Proprietor Just as sole proprietor is the simplest legal structure, it’s the simplest tax structure.
Pros: No separate tax return required. Business income and expenses are reported on Schedule C in the owner’s personal Form 1040. Usually cheaper if you’re paying for tax prep.
Cons: 100% of business Net Income is subject to Self-Employment Tax at 15.3%, equivalent to the employer and employee portions of Social Security & Medicare taxes on payroll. Many tax experts believe Schedule C is more likely to be audited by the IRS than other business tax structures.
Partnership Files Form 1065 to report its activities, and sends Form K-1 to each partner reporting their share.
Pros: Partnerships do not pay income taxes. Its activity is “passed through” via Form K-1 and each partner reports and pays tax on their personal share on their own Form 1040. Partners can agree to share income and expenses unequally for tax purposes (giving deductible expenses to a partner who can most benefit from them, for example).
Cons: 100% of business Net Income is subject to Self-Employment Tax at 15.3%, equivalent to the employer and employee portions of Social Security & Medicare taxes on payroll. Partners generally cannot receive wages or salary for working in the business, and access to employee-type benefits is restricted.
S-Corporation Files Form 1120-S to report its activities, and sends Form K-1 to each partner reporting their share.
Pros: S-Corporations do not pay income taxes. Their activity is “passed through” via Form K-1 and each shareholder reports and pays tax on their personal share on their own Form 1040. S-Corp owners who work in the business can draw salary & benefits as an employee. Distributions to owners outside of salary are not subject to Self-Employment Tax.
Cons: Shareholders who work in the business are required to take a “reasonable salary” even if the business doesn’t make that much, and both the company and shareholder/employee pay payroll taxes on that amount. S-Corp compliance & recordkeeping are more involved than a partnership.
C-Corporation Files Form 1120 and pays taxes on its own net income.
Pros: Corporation’s tax situation is entirely independent of its shareholder owners. Shareholders do not have to pay income taxes on their proportionate share of income, which makes things vastly simpler for a very large company with thousands or millions of shareholders.
Cons: Income can be subject to “double taxation” since the corporation pays tax on income, and the shareholder pays income tax on distributions received from the corporation (which would normally come from that income).
Observation: C-Corp status is mostly used by large or fast-growing companies that are seeking public or venture financing. Rarely is it the best choice for a small business.
So what about LLC’s????
One of the things that makes a Limited Liability Company a unique and popular legal structure is that it gets to CHOOSE its tax structure (within limits) from the list above. Tax pros call this the “check the box” feature of LLC’s.
An LLC with one owner (single member) defaults to being taxed as a sole proprietorship. (Called a disregarded entity, just so you know.)
An LLC with two or more owners (multi-member) defaults to being taxed as a partnership.
Any LLC, regardless of how many member/owners it has, can CHOOSE to be taxed as an S-Corporation or a C-Corporation.
There are no “right” or “wrong” legal structures or tax structures. There are only structures that are “better” for particular situations and needs. If you’re thinking of starting a horse business, or wondering if your current business could benefit from changes in structure, consult your trusted tax advisor. If you don’t already have one, we’re happy to help you fill that role.
****A word of caution**** The information above is very brief and very general. It is intended to give you an overview of the subject. It is NOT intended to be exhaustive, nor is it intended to be advice about what tax structure to choose. Choosing a tax structure for your business based on an 800-word blog post is riskier than buying a horse based on a single photo from a bad angle.