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Should Your Small Business Be An LLC or S Corporation?

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I recently started an internet marketing side business to help small businesses use grassroots strategies to market online using Facebook, Twitter, blogs, and other social media strategies to market their business. I started it with a partner who is also my best friend. While I don’t recommend getting into business with a friend or family member, we’ve known each other for a long time, and there were no virtually no start-up costs to start the business. What we do is mostly consulting, managing, and web developing, so if we dissolve the business tomorrow, neither one of us lose money. However, everyone’s startup is different, and there are two major things you should consider when forming a business: personal liability and tax savings. Today, if you’re making more than a couple hundred dollars a month from your small business or side business, you shouldn’t be operating as a partnership or sole proprietorship. Forming an LLC or an S Corporation is the right move for many different reasons, but which one is better? Let’s take a look at both.

Limited Liability Company

Definition: A flexible form of business enterprise that blends elements of partnership and corporate structures. It is a legal form of business company, in the law of the vast majority of United States jurisdictions, that provides limited liability to its owners. An LLC, although a business entity, is a type of unincorporated association and is not a corporation.

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Advantages

  • Pass-through taxation (won’t be double taxed on profit)
  • Limited liability. You’re relatively shielded from personal liability with respect to the affairs of the business
  • Flexible taxation elections (you can elect to be taxed as a sole proprietorship, partnership, or corporation).
  • Much less paperwork and record keeping than a corporation

The LLC has become a very popular option for start-up businesses and those people with side businesses or small businesses who want and need the liability protection and tax election flexibility. Many people like how easy it is to set up and there is virtually no paperwork to maintain. Depending on which state you live in, you’ll need to speak with someone at your state’s department of business and corporations to find out if LLC’s are offered and if they have any special provisions from other states.

S Corporation

Definition: A corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. In general, S Corporations do not pay any federal income taxes. Instead, the corporation’s income or losses are divided among and passed through to its shareholders. The shareholders must then report the income or loss on their own individual income tax returns.

Advantages

  • Huge tax advantages. Only taxed once, and avoids FICA taxes on profits/distributions.
  • Owners’ personal assets are protected from business debt and liability
  • Corporations have unlimited life extending beyond the illness or death of the owners
  • Tax free benefits such as insurance, travel, and retirement plan deductions
  • Transfer of ownership facilitated by sale of stock
  • Change of ownership need not affect management

An S Corporation is a great choice for a more sophisticated operation with multiple owners/shareholders and for those who will be seeking capital from potential investors. It’s much better than electing to be a “C” corporation, because only the salary you pay yourself out of the “S” corporation is subject to federal AND FICA taxes. The profits/distributions/retained earnings of the “S” corp are only subject to federal income taxes, but not FICA taxes.

What Should You Do?

My business is mostly consulting and managing and there is me and a partner, so we set up an LLC and elected to be taxed as an “S” corporation. What this does is it combines the best of both worlds for the LLC and the S Corporation. We’re an LLC, so that means less paperwork and limited liability, but we get the extra tax advantages of the S Corporation. We can pay ourselves a reasonable salary, then avoid the social security and medicare taxes on the rest of the profits that we earn. If you set up an LLC as a single owner, the default is to be taxed as a sole proprietor, which means you’ll have to pay income taxes and full FICA taxes which is about 15% on ALL net profit, not just the amount you pay yourself. If you’re a single owner or partnership, I would suggest going this route. It makes the most sense, and you get the advantages of both entities. If you think you should set up an S corporation, I would consult a CPA and/or an attorney that specializes in corporations so the paperwork is done right and you can consult with them if it’s truly the best option for you.

Erik Folgate
Erik and his wife, Lindzee, live in Orlando, Florida with a baby boy on the way. Erik works as an account manager for a marketing company, and considers counseling friends, family and the readers of Money Crashers his personal ministry to others. Erik became passionate about personal finance and helping others make wise financial decisions after racking up over $20k in credit card and student loan debt within the first two years of college.

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