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LLC vs S Corp

Defining Benefits

A major advantage of organizing your business as an LLC or an S corp is that you can protect your personal assets from the creditors of your business. "Limited liability means you can't be financially responsible for more than your investment in the company.

Another common aspect of LLCs and S corps is that they help you avoid paying both personal and corporate taxes. The difference is that in an S corp, owners pay themselves salaries plus receive dividends from any additional profits the corporation may earn, while an LLC is a "pass-through entity," which means that all the income and expenses from the business get reported on the LLC operator's personal income tax return.

Both LLCs and S corps can also deduct pre-tax expenses, such as travel, uniforms, computers, phone bills, advertising, promotion, gifts, car expenses, and health car premiums.

LLC Pros:

  • The owner of a single member LLC doesn't have to file a tax return for the LLC, as they only report the activity on their personal tax return.
  • Ease of Set up: Most LLC forms are only a single page for single member LLCs.
  • Inexpensive to Start: The cost of setting up an LLC is also inexpensive, usually just a few hundred dollars.
  • Guidelines: The red tape involved in forming an LLC isn't as stringent as that involved with S corps, which also leads to savings on accountant and attorney fees, among others.

LLC Cons:

  • Self-employment Tax: Single Member LLC owners are required to pay self-employment tax on income generated in the LLC, which means making quarterly estimated payments to the IRS.
  • Owners of LLCs must make sure they don't pierce the "corporate veil," meaning they have to operate the LLC separately from their personal affairs. "The LLC must not be a shell but an operating entity," says Eka. "There have been cases where a business owner lost their protection because there was no distinct difference between the LLC and its owner."

S Corp Pros:

  • The key advantage of an S corp is that it offers tax benefits when it comes to excess profits, known as distributions. The S corp pays its employees a "reasonable" salary, which means it should be tied to industry norms, while also deducting payroll expenses like federal taxes and FICA. Then, any remaining profits from the company can be distributed to the owners as dividends, which are taxed at a lower rate than income.

S Corp Cons:

  • S corps have more strict guidelines than LLCs. Per the tax code, you must meet the following standards to create an S corp:
    • Must be a U.S. citizen or resident
    • Cannot have more than 100 shareholders (a spouse is considered a separate shareholder for the purpose of this rule).
    • Corporation can only have one class of stock
    • Profits and losses must be distributed to the shareholders in proportion to the shareholder's interest. For example, you can't have disproportionate distributions of dividends or losses. If a shareholder owns 10 percent of the S corp, he or she must receive 10 percent of the profits or losses.
  • It costs more to form an S corp.
  • Shareholders must adhere to the requirements at all times. If they don't, they risk disallowing the S corp election and the corporation would be treated as a C corp and its corresponding restrictions.
  • Passive income limitation: You can't have more than 25 percent of gross receipts from passive activities, such as real estate investment.
  • There can be additional state taxes for S corps.
  • Shareholders should pay attention to paying themselves a "reasonable" salary for the work they perform for the S corp since the IRS is increasingly scrutinizing S corps for this.

Keeping Records

"Seven" is a magic number. That is how long the IRS typically has to audit your tax return. Your biggest risk is in the first three years after a return is due; the 2012 return that's due this April can be audited under normal circumstances until April 2016. The IRS can extend that deadline by three years, to April 2019, if it suspects you under reported your income by 25% or more. There's no deadline if you committed fraud or failed to file a return, but we'll assume you're not a crook and have stayed up-to-date. If you write off a bad debt or claim a tax break for worthless securities, you need to keep proof for seven years after filing -- or until April 2020, for your 2012 return