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Llcs, Scorps And Ccorps: How To Incorporate Your Business

Of all the business entities someone could form, the S corporation is likely the most widely misunderstood. Should you structure your business as an S Corp, C Corp or LLC? ' />

Nov 15, 2018 Both limited liability companies (LLCs) and corporations can file to be taxed as an S corp. However, no state offers entrepreneurs the option to incorporate their business as an S corp; instead, those who want an S corp must file a form with the Internal Revenue Service (IRS). Nov 18, 2020 Choosing Your Business Structure for Startups: C Corp, S Corp, LLC, and More Startup Law Resources Incorporate. Choosing the right legal business structure is one of the most important first steps to take as a new business. There are 7 primary structures to consider.

Corps

Of all the business entities someone could form, the S corporation is likely the most widely misunderstood. This is because the S corp is a tax designation rather than an actual business entity. Both limited liability companies (LLCs) and corporations can file to be taxed as an S corp. However, no state offers entrepreneurs the option to incorporate their business as an S corp; instead, those who want an S corp must file a form with the Internal Revenue Service (IRS).

The S corp's somewhat foggy formation process is not the only thing that creates confusion. It is a common misconception that S corps will automatically save owners 15% on their taxes. To dispel any myths and explain more about S corporations, below you'll find a complete breakdown of what the S corp actually is, how to form one, and what you should know before you do.

Llcs S Corps And Corps: How To Incorporate Your Business Plan

What is an S Corporation?

The S corporation is a tax designation that a corporation or LLC can elect by filing Form 553: Election by a Small Business Corporation with the IRS. It’s a popular tax election because it has tax-saving potential for both corporations and LLCs.

The S election gives a corporation the tax advantages of a pass-through entity. The S election can also give an LLC the tax advantage of corporate distributions, which aren’t subject to self-employment taxes. These tax benefits are explained in detail below.

Tax Benefits: S Corporation vs C Corporation

When someone forms a corporation, it is by default taxed as a C corporation. The money a C corp earns as net profit (the money left over after salaries and other expenses have been paid) will be taxed. Then, the net profit that is left over and not kept in the company will be distributed to the shareholders as dividends.

On these dividends, the shareholders will have to pay personal income tax. Essentially, the net profit of a C corp is taxed twice—once as a corporation tax, then again as personal income to the shareholders. This is known as double taxation.

The S corp tax designation allows corporations to avoid double taxation. S corps are pass-through tax entities. This means that the corporation itself is not taxed on its profits. The profits are passed onto the shareholders and are taxed as personal income, much the way an LLC is taxed.

Tax Benefits: S Corporation vs Default LLC

As explained above, the S election allows a corporation to avoid double taxation. LLCs, by default, are also taxed as pass-through entities, avoiding double taxation. Just like in an S corp, profits in an LLC pass directly to the members and are taxed as personal income.

In other words, LLCs don’t really gain any benefit from an S corp’s pass-through entity status. However, there is a different advantage an S election can give an LLC: self-employment tax savings.

For an LLC that keeps its default tax status, the IRS considers all the income passed through to members to be self-employment income. This means that the members of an LLC must pay self-employment taxes on their entire share of income—and these are hefty taxes. Self-employment taxes include social security (12.4%) and Medicare (2.9%), totaling 15.3%.

S corps, on the other hand, are allowed to pay out dividends to their shareholders. Dividends come from the net profits —what's left over after all expenses are paid. Shareholders are not required to pay self-employment taxes on these dividends, which is a savings of 15.3%.

However, there is a catch: The IRS requires that active owners of S corps (those who provide more than minimal services) pay themselves a wage, and the wage must be 'reasonable compensation.' That means you can't simply take all the S corp profit as a dividend —you must pay yourself a reasonable wage, which will be taxed as standard payroll wages.

Llcs, Scorps And Ccorps: How To Incorporate Your Business

S corp owners can only reap the 15.3% tax savings on dividends.

Business

When to Choose the S Election

Because S corps owners are required to pay themselves a salary and receive the tax benefit only on dividends, many businesses choose to wait to elect S corporation status until the income the company generates makes the tax designation worthwhile. As a general benchmark, many entrepreneurs will wait until their company starts clearing $50,000 of annual profit. Because of the expenses incurred through payroll services and general W2 wages, $50,000 is where things start to make fiscal sense.

For example, if you took in $50,000 and paid yourself a $40,000 salary, you would have $10,000 left over as a dividend payment. At that point, the tax savings on the $10,000 dividend ($1,530) would likely cover payroll expenditures.

S Corporation Requirements

Although the S corp can present entrepreneurs with a wide range of advantages, it is not without its restrictions. Below are requirements for LLCs and corporations seeking S corporation tax status:

  • LLCs and corporations that file to be taxed as an S corp must be domestic companies
  • Shareholders or members of S corps must be individuals, estates, or certain types of trusts; S corp shareholders cannot be partnerships, other corporations, or non-U.S. residents
  • S corps may only have one class of stock
  • An S corp may have no more than 100 shareholders (or members if an LLC)
  • Certain types of corporations do not qualify: some financial institutions, insurance companies and domestic international sales corporations
  • All shareholders or members must pay themselves a reasonable salary
  • Shareholders or members are directly responsible for the profits and losses according to their share of ownership

Filing Form 2553

As mentioned above, to apply for S corporation tax status, you’re required to fill out Form 2553 with the IRS. The form is fairly straightforward. However, there are a few key details about the form itself that you should know before you begin:

  • You must file for the S corp tax designation no later than two months and 15 days after the first day of the taxable year
  • On the form, you must include each shareholder or member’s name, address, social security number (or EIN if applicable), and tax year end date
  • You must also list each shareholder or member’s number of shares or percentage of ownership, as well as the dates the shares or percentages were acquired
  • All shareholders or members must consent to the S corp election by signing and dating Column K of the form

For thorough instructions on filing for the S election, see the Instructions for Form 2553.

Final Considerations

Although the S election has developed a reputation as an optimal tax designation, it isn’t always the best choice for every business—particularly if your business isn’t making enough money to cover the mandatory salary requirement of “reasonable compensation.” Additionally, many businesses are not able to qualify for the S election at all due to the restrictions on stock classes, shareholders, domesticity, and areas of business. In fact, there are many misconceptions about S corporations to consider before electing with the IRS.

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It’s also important to remember that the S election is a federal tax designation, affecting your federal taxes. State taxes may be very different, so it’s a good idea to research how your state treats S corporations.

Most states recognize the S election and will tax your business in much the same way as it is taxed on the federal level. However, some states don’t recognize the S election for state-level taxes and others have franchise or excise taxes that may apply to S corporations.

That said, the S election has greatly benefited some corporations and LLCs with considerable tax savings. Just remember that no single tax designation is inherently superior—it’s all about what’s best for your business

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Written by: Andrew Gale - Orange County - Small Business Attorney

In California, a Limited Liability Company (LLC) and a Corporation are two of the business structures that offer liability protection to the owners of the company. Although they are very similar, they have many important differences too. If you’re wondering which corporate structure you should choose, read through this article. This article is a comparison between LLCs and Corporations.

What does it Mean to Incorporate a Business in California?

When a business incorporates, its business structure moves from being a sole proprietorship or general partnership to a structure wherein it becomes a separate entity from its owners. The law recognizes the company by its state of incorporation, which may either be a Limited Liability Company or a Corporation. There are various subtypes of corporations but the most popular types in California are S Corporations (S Corps) and C Corporations (C Corps). All of these 3 corporate structures offer the advantage of being protected from personal liability and having increased credibility with customers. As much as there are many advantages with these types of business structures, each also has their disadvantages.

1. Limited Liability Company

Limited Liability Companies in California

The owners of a Limited Liability Company are referred to as members. An LLC protects its members from being personally liable for any actions of the company. This means that if a lawsuit were to arise concerning the business, your personal assets are kept safe.

Unlike corporations, LLCs offer more flexibility in the management of the business. In corporations, there is a management structure that needs to be followed, like having directors oversee the major decisions that need to be made while officers are assigned with the daily operations of the business. LLCs, on the other hand, do not have this strict structure. The members may manage the daily operations or they can have an individual or a team assigned with the task.

Llcs S Corps And Corps: How To Incorporate Your Business Effectively

In an LLC, pass-through taxation is applied. This means that taxes are not paid at the business level. Instead, the company’s income and losses are reported on the members’ tax returns. Taxes are paid, therefore, on the individual level only.

Unlike S Corporations, LLCs have fewer restrictions on who can be an owner of the business and on how many owners there can be. Moreover, LLCs have fewer state-imposed annual requirements and other formalities compared to corporations.

Corporations in California

There are basically many types of corporations in California but the most popular types are S Corporations and C Corporations. The type of corporate structure you choose depends on the goals of your business.

Similarities between S Corporations and C Corporations

Basically, a C Corp is the regular corporation and an S Corp is a C Corp that has applied for a special tax status with the IRS. The S Corp gets its name because it is defined in Subchapter S of the Internal Revenue Code. In order for a C Corp to become an S Corp, it has to file Form 2553 with the IRS and meet all the S Corporation guidelines.Llcs, Scorps And Ccorps: How To Incorporate Your BusinessBoth S Corp and C Corp offer liability protection to their owners. The shareholders, who are recognized as the company’s owners, are not personally responsible for any debts and liabilities that the business may incur. This is because both types of business structures are considered by the state as separate legal entities from their shareholders.S and C Corporations have similar management structures. They both have shareholders, a board of directors and officers. The shareholders are the owners of the corporation, and they elect the members of the board of directors. The directors are responsible for overseeing and directing corporate affairs and decision-making. Officers, on the other hand, who are elected by the directors, are responsible for the day-to-day operations of the company.Articles of incorporation, also known as a certificate of incorporation, need to be filed with the California Secretary of State in order to form both C and S Corporations.

Differences between S Corporations and C Corporations

S Corps differ from C Corps in many ways, and the most prominent difference is in their taxation. C Corporations are separately taxable entities. Taxes are paid at the corporate level and therefore you must file a corporate tax return (Form 1120). In cases wherein a corporation’s income is distributed among the shareholders as dividends, double taxation may apply because dividends are considered as personal income. Tax, therefore, is first paid on the corporate level and then again at the individual level on dividends.S corporations, on the other hand, are pass-through entities just like LLCs. S Corps need to file an informational federal income return (Form 1120) and no tax is paid at the corporate level. Instead, the profits and losses of the company are “passed through” the corporate level and reported on the shareholders’ personal tax returns. All taxes are paid at the individual level.In terms of ownership, C corporations do not have restrictions while S corporations do. S Corps are allowed to have no more than 100 shareholders and all of them should be US citizens or residents. S Corps cannot be owned by C Corps, other S Corps, LLCs, partnerships or trusts. Unlike C Corps, S Corps are not allowed to have more than one class of stock.

Other Differences between LLC, S Corps and C Corps.

The advantage of being an S Corp is that business owners can use the losses of the company as deductions on their personal tax returns. Unlike C Corps, which are taxed as a completely separate tax entity, S Corps can also provide savings on self-employment, security, and Medicare taxes. S Corps allows the shareholders to offset their non-business income with the losses from the business.

LLCs and C Corps do not have restrictions on the number of allowed business owners but S Corps do. S Corps should have a maximum of 100 shareholders who are all residents and citizens of the United States. Unlike LLCs and C Corps, S Corps cannot be owned by C corps, other S Corps, LLCs and certain trusts.

Many developing businesses in California often choose to be C corps instead of other business structures because the stockholders can hold different classes of stock interests including preferred and common stock. This variety in classes of stocks allows different levels of dividends. This also attracts venture capitalists and investors.


Corps

Andrew Gale – Incorporation Attorney

Attorney at Law Offices 1820 West Orangewood Avenue, Suite 104a, Orange, CA 92868Office: +1 (714) 634-4838. I provide legal advice, counseling and related services to entrepreneurs including the formation and management of their corporations and estate plans.

My Law Office is based in Orange County California and I have practiced law for 30 years. I have given advice to more than 1000 small business owners on the best ways to set up a company, what types of business entities (corporations, limited liability companies, partnerships) are best suited for them and their small business, how to legally run the business to protect their assets and how to successfully transfer the business to family or key employees through the proper use of estate planning and trusts.

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