You are going into business with one or more partners. Some of you may work actively for the business, while others may be passive investors and recipients of profits.
Right now, we need to decide whether the business should be a partnership, an LLC, or a corporation, and how it should be taxed. Both an LLC and a corporation can limit the owners’ liability for obligations and mistakes of the company. But these two types of entity can have different accounting and taxation of ownership interests and profits.
An LLC has less book-keeping than a corporation and allows more creativity in how the finances and management are structured. An LLC typically is taxed as a partnership, with K-1s being provided to the partners and all the LLC’s profits flowing through to the partners’ personal tax returns as business income. Partnership income is taxable as self-employment income. However, an LLC can elect to be taxed as an S-corp or a C-corp. Equally, a corporation can elect to be taxed as an S-corp or a C-corp.
Practically speaking, S-corp taxation of an LLC sometimes is better for the owners of simpler businesses who plan to work in the business, plan to share profits after salaries according to their ownership interests, and do not plan to have a lot of investors. But S-corp taxation requires a more complicated operating agreement, limits how profits may be allocated, and also limits how many shareholders the company can have (100 or fewer).
When an LLC is taxed as a partnership or as an S-corp, it will operate as a “pass-through” entity where profits and losses flow directly to the owners’ personal income taxes. One way the two structures are different is that an LLC taxed as a partnership may allocate profits and losses any way you would like, whereas an LLC taxed as an S-corp must allocate net profit according to each owner’s percentage of outstanding shares. Another way the structures differ is that all of the LLC profits that are allocated to a member may be subject to self-employment tax (and can earn credits toward Social Security), whereas S-corp dividends are not subject to self-employment tax (and do not earn Social Security credits).
An LLC may not have its owners (members) as employees for most purposes, although an LLC owner may be treated as an employee for workers compensation claims if the LLC has paid appropriate taxes. On the other hand, an S-corp may employ its owners (shareholders).
Being able to employ an owner means that the business can offer somewhat tax-advantaged benefits to the owner-employee (e.g., health care coverage and retirement plan), can pay unemployment and workers’ compensation insurance for the owner-employee, and is responsible for the company share of Federal payroll taxes on the owner-employee’s wages (which credit the owner-employee for Social Security). Please consult with your accountant for more information about the business and personal tax implications whether you are treated as an owner or an owner-employee.
I hope that this information is helpful.
