The most popular choices for a small business entity are S-corporation and LLC (Limited Liability Company). Both entity types provide legal protection and have income pass through to owners. There are many similarities between them, but also very big differences. Choosing the right entity may save you thousands of dollars in taxes. Depending on where the entity is formed, different rules may apply, so for this article let’s take a closer look at the S-corporation and LLC that are formed in the state of California.
The S-corporation and LLC are a relatively new form of organizations. The S-corporation was started with Republican President Dwight Eisenhower’s recommendation to Congress. During this time in the U.S., there was concern in Washington that too much economic power was held by mega sized public C-corporations and a sense of fear began that small business ownership will be a thing of past. So, congress finally created subchapter – S in 1958 to support the small private businesses. Since then it became the most popular form of small business entity, numbering over 4.5 million. The LLC is an even newer form of entity in the U.S., but it is not so new in other countries like in Europe and South America. It actually started in Germany in 1892,then quickly spread out to countries like Portugal (1917), Brazil (1919), Chile (1923), France (1925), Mexico (1934), Belgium (1935), Switzerland (1936), Italy ( 1936), and Peru (1936). In the U.S., the LLC started in Wyoming which enacted a true LLC Act in 1977 modeled after the 1892 German company law. And soon other states, like California, adopted the LLC law and the number of LLC’s grew exponentially. In fact, there were only about 120, 000 LLCs in 1995, but well over million today. You may wonder why these two forms of entities are so popular among small business owners today and here is why.
The traditional C-corporation has two levels of income taxes. The first is the corporation level and the other is the shareholder’s level. While there are many benefits associated with C-corporations and ways to minimize the double taxation effect, nevertheless, a S-corporation and LLC does flow through the income to the individual level and pay no taxes at the corporate level while enjoying the legal protection like that of a C-corporation. This is one of the major reasons why S-corporation and LLC is so popular among small business owners today. It is true that flow through entities does not pay entity level taxes, but that only applies to the federal level and not the state level. States, like California, impose entity level taxes on flow through entities like S-corporations and LLCs. This will be one of the major areas why you should consider S-corporation over LLC or vice versa.
In California, S-corporations are subject to a 1.5% income tax on their net income, but the LLCs are subject to taxes based on their gross receipt and not their net income with a fixed percentage. Here are LLC tax amounts based on the gross receipts: $900 for gross receipt of $250,000 ~ $ 499,000, $2,500 for gross receipt of $500,000 ~ $999,000, $6,000 for gross receipt of $1million ~ $4.99million, and above $5million is $11,790. To see the difference easily, let’s use real numbers. There are companies A & B. Company A has a gross revenue of $1million and a net income of $200,000 and company B has a gross revenue of $4million and a net income of $800,000. In the case of company A with S-corporation status, $3,000 ($200,000 x 1.5%) must be paid to the state, but with LLC status, it must pay $6,000 to state. In the case of company B with S-corporation status, $12,000 ($800,000 x 1.5%) must be paid to the state, but with LLC status, it must pay the same amount of $6,000 to the state. So here is the tax saving ideas, if your company is extremely profitable, generally LLC will save thousands in taxes over S-corporation, but if your company has a very large gross revenue, but a very small net income or even a loss then S-corporation is better.
There are more factors to consider before you make your decision. For example, active incomes generated by LLC which then flow through to individuals are subject to SE taxes (Self-Employment Taxes 15.3%) which could be thousands of dollars, but this does not apply to income flow through from the S-corporation. In some cases, even if LLC pays more in taxes than an S-corporation, you should choose LLC over S-corporation. For example, if you are a land lord and would like to protect your personal asset from other liabilities associated with this rental property then a LLC is generally much better than an S-corporation because it may become a taxable event if you decided to take your appreciated rental property out of your S-corporation, however, this does not apply to a LLC. Also, incomes from rental and investment activities are generally not subject to SE taxes in LLC and the heirs may receive benefits of step up basis to reflect the fair market value of assets if the owner of the LLC dies. Furthermore, LLCs will allow foreigners to be its members and there are no restrictions in the number of owners, such as the case for S-corporation. Such benefits and flexibility of LLCs are the reason why the numbers of LLCs formed in the U.S. are growing faster than any other business entity. The above mentioned are simple examples, and many more are not explained in this article. Please consider all other factors that may affect the benefits of forming an S-corporation or a LLC before you make your decision.
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