Entrepreneurship has been called the new American dream. If you are hanging a shingle, you are in good company. Starting a new business in 2021 statistics include :
- 90% of new American billionaires are self-made.
- In 2016, 25 million Americans were starting or already running their own business.
- The number one reason why businesses fail is the lack of market need.
- 46% of small business entrepreneurs are between the ages of 41 and 56.
- There are 582 million entrepreneurs in the world.
- 20% of small businesses fail within the first year.
A new business starts with an idea that develops into a plan, but not without careful financial and legal considerations. Among the decisions you may grapple with as a new business owner, your tax designation is one of the first. Since you want your business to squarely land in the 80% of startups that make it through the first year, it is essential to think about your tax status structure since this is a large chunk of how much you will pay the feds and the state each year.
Tax Designation Options
You may wonder whether to form an LLC taxed as a partnership or a corporation taxed as an S corporation. When starting a new business, this one decision can cost or save your new business thousands. Learn how to think about the different designations and make the best choice for your new business.
There are similarities and differences between LLCs and S corps that business owners should understand before choosing between the two. Let’s examine why you would use each of these structures: LLC (Taxed as a Partnership) or an S Corporation.
Both Structures Limit Liability
You can create both S Corps and LLCs by filing the necessary paperwork with the state. Unlike a sole proprietorship or a general partnership, the state does not recognize LLCs and corporations under state law until you file.
In addition to the state filings required to form the corporation, the state requires a special filing on Form 2553 for the state-law corporation to elect S status for federal tax purposes.
Both entities provide owners with limited liability. This type of liability protects your personal assets from any business creditors’ claims.
Pass-Through Entities
Both LLCs and S corps are pass-through tax entities. Pass-through entities allow business profits and losses to flow through and report on the owners’ personal tax returns. S Corps and LLCs do not pay corporate income tax in North Carolina. However, North Carolina S corporations must pay the franchise tax.
Ownership Differences
Unlike LLCs, which can have an unlimited number and type of owners, S corps are subject to strict ownership rules. S corps can have no more than 100 shareholders, may not have non-U.S. citizens as shareholders. S Corps strict ownership rules mean that these entities cannot legally own an S Corp:
- Corporations
- LLCs
- Partnerships
- Many types of trusts may not legally own an S Corp.
As opposed to LLCs, which have flexibility in structuring the economic arrangement among its owners, S corps cannot issue classes of stock with different economic rights. However, an S corp can issue voting and non-voting classes of stock.
Management Rules
S corps are subject to mandatory management requirements. For example, state and federal law requires S corps to adopt bylaws, issue stock, hold regular meetings, and maintain meeting minutes within its corporate records.
LLCs, on the other hand, are not subject to these types of requirements.
Self-Employment Tax
Owners of S corps, unlike LLCs, may be able to reduce or eliminate the need to pay self-employment tax. An S corp owner has several advantages in this way. S corp owners can be:
- Treated as an employee
- Paid a reasonable salary
- Have employment taxes withheld from the reasonable salary
- Earn “unearned” income from the corporate earnings above the salary. This unearned income is free of self-employment tax.
Profit Distribution Rules
S corp owners must share profits equally based on their percentage of ownership, while LLC owners have wide latitude to split profits and losses in any agreed manner.
S corps generally provide enhanced asset protection, as the structure creates more separation between the owners and the company.
Another Option: State LLC Taxed as Federal S Corp
For the sake of simplicity, so far, we’ve only looked at:
- LLC taxed as a partnership
- S corporation taxed as an S corporation
However, there is another choice for partners in an LLC. An LLC can set up shop as an LLC partnership at the state level while also choosing to be taxed as an S corp under federal law. Choosing these tax designations is quite common. In many cases, the business owner desires a few things:
- Avoid strict state law corporate compliance.
- Take advantage of the favorable S corp taxation from the federal government
We Can Help
Each business has its own set of circumstances to consider. Our experienced business law attorneys are here to work through how to structure correctly, form, and protect your business. We work extensively with new tax and business laws at the state and federal levels that affect your bottom line. Contact us today to find out how we can help you make the best decisions for your new business.