16 Oct LLC or S Corp.? Benefits for new biz

Q. I want to start a new business, and for now I will be the only employee. How do I choose between an LLC or an S Corp.?
— Getting started

A. A new business can be a very exciting proposition.

As a start-up with no employees, you should be concerned with getting liability protection with minimum administrative burden.

Both an LLC and an S Corp. provide business owners with personal liability protection, limiting any liability to assets owned by the business entity itself, said Steven Gallo, a certified public accountant with U.S. Financial Services in Fairfield.

Gallo said the main reason for using either one of these business entities is to provide protection for the owner’s personal assets from liabilities arising from business activities.

Both of these entities provide pass through taxation for the owner, meaning that neither pays a tax at the entity level. All profits pass through to the owner’s personal tax return and are taxed at his or her personal tax rates, he said.

The main differences between the two entities lie in the areas of administration and compliance.

“As a sole member LLC, no additional tax returns need to be filed. The owner simply reports all business activity on a Schedule C attached to their personal tax return,” Gallo said.

The owner will be responsible for both income tax and self-employment tax (Social Security tax) on the net profit of the business, which is payable when filing their 1040 return, he said. The owner is free to draw income from the business as he or she sees fit at any time during the year, and should be paying estimated taxes during the year to cover the taxes due on the business profit.

An S Corp. requires the preparation and filing of a separate corporate return (Form 1120S) on an annual basis, Gallo said.

“Part of this return will be a Schedule K-1, which will tell the owner how much income they need to report on their personal return,” Gallo said. “The owner would be required to take their income during the year through payroll, therefore requiring payroll processing and the preparation of monthly payroll tax return filing.”

Both the preparation of the 1120S and payroll processing will result in additional costs to S-Corp. owners.

Gallo said the S Corp. owner would be required to take a fair and reasonable salary.

“This amount would be subject to Social Security tax, half paid by the employee (owner) and the other half paid by the S Corp., so there is no increase in cost there,” Gallo said. “The owner salary is treated as a tax deduction for the S Corp.”

He offered this example: Let’s assume the business has a $50,000 income and that a fair and reasonable salary is $35,000. The $35,000 salary would be subject to Social Security tax, and the balance of $15,000 would only be subject to income tax.

“Therefore for Income tax purposes, there is no difference,” he said. “In the case of the LLC, the entire $50,000 would be subject to both income tax and Social Security tax, resulting in a higher Social Security tax cost of approximately $2,000 — however, the LLC owner would also be getting credit for higher Social Security earnings therefore increasing their potential Social Security benefits.”

So there are pros and cons to both types of entities, but Gallo said he prefers the LLC for someone in your situation because the LLC provides a lighter administrative burden to the small business owner with greater flexibility while providing adequate liability protection.

Either way, make sure you keep your business and personal finances separate, and don’t forget to consider your retirement saving options.

Consider meeting with a financial professional who can further discuss your options with you after hearing more about your plans for the business. And let us know how you make out!

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This story was first posted in October 2015.