Let's assume that you've concluded it would be advantageous to operate your small business through an entity that limits the personal liability of all the owners—even if following this strategy involves a bit more paperwork, complexity, and possible expense. You have two main choices—either the tried and true corporation or the new and streamlined limited liability company (LLC). Which is better? There's no answer to this question that applies to every business. Nevertheless, some general principles may be helpful.
For the majority of small businesses, the relative simplicity and flexibility of the LLC makes it the better choice. This is especially true if your business will hold property, such as real estate, that's likely to increase in value. That's because regular corporations (sometimes called C corporations) and their shareholders are subject to a double tax (both the corporation and the shareholders are taxed) on the increased value of the property when the property is sold or the corporation is liquidated. By contrast, LLC owners (called members) avoid this double taxation because the business's tax liabilities are passed through to them; the LLC itself does not pay a tax on its income.
An LLC isn't always the best choice, however. Occasionally, other factors will be present that may tip the balance toward a corporation. Such factors include the following:
The corporation can deduct the cost of these benefits and they are not treated as taxable income to the employees, which can be an attractive feature of doing business through a regular corporation. With an LLC, you can only deduct a portion of medical insurance premium payments, and other fringe benefits provided to members do not receive as favorable tax treatment.
Self-employment taxes can tip the balance toward S corporations, since LLC owners may pay more. What are self-employment taxes? Well, you know that taxes are withheld from employees' paychecks. Employers must withhold 7.65% of an employee's pay up to an annual threshold ($137,700 in 2020, up from $132,900 in 2019) for Social Security and Medicare taxes, and 1.45% of earnings above that amount for Medicare taxes alone. The employer adds an equal amount and sends these funds to the IRS so the total sent to the IRS is 15.3% on wages up to the annual threshold and 2.9% on anything above that.) You may not be aware that the IRS collects a similar 15.3% tax on a self-employed person's wages up to the annual threshold and 2.9% tax on earnings above that amount. This is the self-employment tax.
For an S corporation, the rules on the self-employment tax are well established: as an S corporation shareholder, you pay the self-employment tax on money you receive as compensation for services, but not on profits that automatically pass through to you as a shareholder. For example, if your share of S corporation income is $100,000 and you perform services for the corporation reasonably worth $65,000, you will owe the 15.3% self-employment tax on the $65,000 but not on the remaining $35,000.
By contrast, the self-employment tax may be imposed on an LLC owner's entire share of LLC profits. However, the rules for members of an LLC are murky.
Proposed IRS regulations (which Congress has placed on indefinite hold) would impose the self-employment tax on an LLC owner's entire share of LLC profits in any of the following situations:
Until the IRS clarifies the rules on self-employment tax for members of an LLC, you should assume that 100% of an LLC member's earnings will be subject to the tax.
Therefore, an S corporation shareholder may pay less self-employment tax than an LLC member with similar income. You'll need to decide if this potential tax saving is enough to offset such LLC advantages as less formal record keeping and flexibility in management structure and in the method of distributing profits and losses.
You will probably find that you need more help deciding which structure is best for your business. A good small business or tax lawyer can help you choose the right one, given your tax picture and the possible risks of your particular situation. You might also benefit from reading Nolo's book, LLC or Corporation? How to Choose the Right Form for Your Business, by Anthony Mancuso.