When starting a business, the form of entity should be part of a well-thought-out business plan that considers the needs and desires of both the business and the owner(s). As much as possible, the decision should take into account where the business is headed in the future.
“The LLC has become a very popular option, but it may or may not be the right form for a particular business,” says John T. Alfonsi, CPA/ABV, CVA, CFE, partner, Cendrowski Selecky PC, Bloomfield Hills.
Smart Business spoke with Alfonsi about the various forms of business entities.
What options are available for a business entity?
Primarily, a business can be structured as a C corporation, an S corporation or a Limited Liability company (LLC). With an S corporation or an LLC, there is a single level of tax at the owner level. With a C corporation, there are two levels of tax: one at the entity level and one at the owner level when earnings are distributed. Many times, a particular legal structure or strategy should be considered when forming a business.
What are the major differences between the choices?
From a tax savings perspective, there is an advantage to being an S corporation or an LLC if you experience losses in the first few years, which can ‘flow through’ to the owner. With a C corporation, losses cannot be used by the entity until the company starts achieving a profit.
The LLC is a state law concept. LLCs are formed under state laws, not federal guidelines. For federal tax purposes, when there is one owner, the entity is disregarded and the owner is considered a sole proprietor. If there is more than one owner, the entity is taxed as a partnership. The owners can elect to be taxed as a corporation but most do not.
The S corporation is a convention of federal tax law. An S corporation elects to have only one level of tax. The shareholders elect to pay tax on income whether or not it is distributed.
With both an S corporation and an LLC, if there is a profit, the owners have to pay tax on it whether or not they receive any money. The LLC tends to be the most flexible in terms of how income and cash is distributed.
How do S corporations and LLCs differ?
The biggest difference is that the allocation schemes are limited with an S corporation. With the S corporation, there can only be one class of stock. Everything must be shared pro rata among the owners: the income earned, distributions. Many businesses want flexibility, however, in how to allocate income and cash between the owners so, if that desire exists, the better option may be the LLC. But the disadvantage compared to the S corporation is the self-employment tax. In an LLC, if you’re acting like a general partner, you are subject to the self-employment tax on 100 percent of your share of the earnings whether or not they are distributed.
An S corporation is a separate entity for tax purposes. So the distributed share of income is not subject to the self-employment tax. A portion of the income is taken as a salary, subject to normal payroll taxes. For instance, if $100,000 in revenue is generated and the owner takes a salary of $20,000, the entity and the owner pays payroll taxes on the $20,000. The remaining $80,000 is not subject to self-employment tax, only income tax, and it can be withdrawn generally without any further tax consequences.
What are the advantages of each form of ownership?
The single level of tax is an advantage for both the LLC and the S corporation. The S corporation offers the potential to mitigate the self-employment tax, but you are limited to 100 shareholders. You are also limited with what types of entities or persons can be shareholders. With an LLC or a C corporation, the number and type of owners is unlimited.
If equity-based compensation will be offered, it is advantageous to form as a C corporation, where the compensation will be easier to comprehend. It is also prudent to form as a C corporation if there are future plans to go public. The C corporation is also the only corporate option that allows you to offer preferred stock.
In many cases, the LLC is recommended for a start-up because of its flexibility. If the self-employment tax is a concern, there are ways to mitigate it, such as becoming third-party managed or by having a managing member receive guaranteed payments for his or her services.
JOHN T. ALFONSI, CPA/ABV, CVA, CFE, is a partner at Cendrowksi Selecky PC, Bloomfield Hills, Mich. Reach him at (248) 540-5760 or firstname.lastname@example.org.