If you’re thinking of starting a new business, you have many decisions to make. In our last blog, we discussed three entity types, sole proprietorship, C corporation, and partnership. In this next installment, I want to talk about two other entity types:  S corporation and Limited Liability Company.

S Corporation

Like the C corporation discussed in the last blog, legal documents are required when starting the S corporation. The maximum personal liability for the shareholder in the corporation is what they have invested in the business. The S corporation files its own tax return (Form 1120S). 

The S corporation differs from the C corporation in several areas. The maximum number of shareholders in an S corporation is limited to 100. Shareholders in an S corporation must be US citizens or permanent residents. A trust is not allowed to be a shareholder in an S corporation unless it is a qualified subchapter S trust, a grantor trust, a revocable trust, or a trust created as part of an estate. 

Similar to partnerships and sole proprietorships, the owners of the S corporation pay income tax on their share of the corporation’s income even if they don’t receive any distributions from the business. Any distributions received by the shareholders are not taxed again. 

While owners of sole proprietorships and partnerships are required to pay self-employment tax in addition to income tax, S corporation shareholders may be able to shield some of the business income from the self-employment tax.  In order to utilize this provision, the owner or owners of the S corporation must receive a “reasonable” salary from the corporation. Any net income after paying a reasonable salary is not subject to self-employment tax. 

Limited Liability Company (LLC)

Similar to the corporations, legal documents are required to set up an LLC. The owners’ personal liability is limited to the amount invested in the business. Like the S corporation, there is no double taxation on distributions taken out of the business. All business income is taxed, though, even if it is not distributed out to the owners. 

If the LLC has only one owner, the owner can decide whether to file as a sole proprietor or as an S corporation. By choosing to file as a sole proprietor, the owner reports all income and expenses of the LLC on Schedule C of their Form 1040. If the owner chooses to file as an S corporation, the owner first needs to file Form 2553 to make the S corporation election. There will be a separate tax return (Form 1120S).  As discussed earlier, if the owner receives a “reasonable” salary, the remaining taxable net income of the LLC will not be subject to self-employment tax.

If the LLC has two or more owners, the owners still have a choice—file as a partnership or as an S corporation. Either way, they will have a separate tax return for the business—Form 1065 for the partnership or Form 1120S for the S corporation. All of the partnership income will be subject to self-employment tax. If the owners choose to file as an S corporation, they will need to file the election (Form 2553) and pay themselves a “reasonable” salary to avoid the self-employment tax. 

The option that is best for you will be dependent on a number of personal factors. Working with a business attorney, accountant or other professional is the best way to make a final decision. If you want to chat more about different types of business entities, I’m always happy to connect!

Judith Ackland has more than 26 years of experience in accountancy and financial planning, including seventeen years as a CFO of a diverse business. She started Crystal Financial in 2010 to help a wide array of individuals, families, and business owners better understand their finances and how good financial management could help them achieve their goals. Judith has an MA in Professional Accountancy from the University of Nebraska at Lincoln as well as a Certified Public Accountant Certificate and a Certified Financial Planner designation.

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