Should I Be An LLC Or Should I Be An S-Corp?

...And The Surprising Misconception About Choosing Between an LLC and S-Corp

When starting a new business, one of the first big legal and financial decisions you may inevitably face is whether or not to form an LLC (limited liability company)

BENEFITS

Starting an LLC has several benefits: The most important reason to form one is built right into the name, Limited Liability Company. It limits liability. This means that the owner's personal assets are generally protected from business debts and liabilities forming a "shield of protection" meaning if the LLC incurs debts or faces legal action, the owner(s) personal assets (such as their home or personal savings) are typically shielded from creditors.

Operating as an LLC can enhance the perceived credibility and professionalism of the business as many clients and partners prefer to work with entities that have a formal legal structure, such as an LLC, rather than sole proprietorship.

LLCs also simplify transferring ownership interests or bringing in new co-owners (members). The death or incapacity of a sole proprietor can raise issues regarding the continuity of the business, whereas an LLC can have provisions in its operating agreement to address these situations.

Setting up an LLC is fairly straightforward. You choose a business name and submit articles of organization with your state agency. While you can use a specialized service, be sure they are reputable. Some states require an operating agreement, but if your doesnt, you should have one. Its like a playbook that lays out the rules for ownership, management and continuity provisions. Periodically documenting major decisions through formal minutes is also recommended.

BANKING & CREDIT

Establishing bank accounts and building business credit are vital steps for any new business. Operating as an LLC can simplify opening business bank accounts and establishing business credit. Banks often have streamlined processes for legal entities like LLCs to open accounts, whereas sole proprietors and partnerships typically need to provide extensive personal information and guarantees.

Additionally, an LLC allows business owners to separate personal and business finances.

One mistake owners make is using personal bank accounts for business expenses. Even if expenses are tracked and accounted for, commingling funds makes asset protection unclear as there is no clear line where one ends and the other begins. If legal action occurs, courts may "pierce the corporate shield" and expose personal assets by linking them to the business. Maintaining separate accounts avoids this major liability risk.

TAXATION AND THE S-CORP

The ability to deduct ordinary and necessary business expenses is one tax advantage of being a small business owner, even without a formal LLC structure.

Forming an official LLC does not provide additional tax savings, but it does offer tax flexibility.

When I am speaking with people about scalingtheir business, a question I am often asked is: SHOULD I BE AN LLC OR AN S CORP?

I have heard many people weigh in with their opinion, articulating whether they think someone should be an LLC or an S Corporation. I was just listening to a podcast where two business "gurus" debated back and forth about why you should be one or the other. Unfortunately, they are misinformed. In fact there is a lot of bad advice from people who don't know and don’t understand that THEY ARE NOT THE SAME THING!

It's like asking someone if you should wear a shirt or a jacket.

An LLC, similar to a corporation, is an entity formation - it creates a legal entity that separates your business from YOU the individual.

An S-Corp is a tax election under subchapter S of the Internal Revenue Service tax code. So, the correct answer is, YOU CAN BE BOTH.

From a tax standpoint, LLCs are not recognized by the IRS. By default, a single member LLC is treated as a sole proprietorship and a multi member LLC is treated as a partnership.

Subchapter S allows a qualifying business (whether an LLC or a Corporation) to be taxed like partnerships or sole proprietorships while still being legally organized an separate from the individual(s). It’s also interesting to note that an LLC may also elect to be taxed as a C-Corp for tax purposes, one reason giving them the ability to defer taxes.

There are certain criteria that an LLC must meet to qualify for Subchapter S status, and there are some limitations as well. It's potentially beneficial to be an S-Corp beyond the $50,000 mark due to potential self-employment tax savings. However, other factors like your income, state taxes, and business expenses play a significant role. Additionally, S-Corps require paying yourself a reasonable salary and associated payroll taxes, which need to be factored into the equation. Remember that S-Corps also have limitations, such as restrictions on ownership types and number of shareholders. If you decide to pursue an S-Corp election you would fill out a form to submit to the IRS.

In summary, forming a Limited Liability Company (LLC) offers important benefits for new business owners by limiting personal liability exposure, "shielding" personal assets from company debts or legal disputes. However, you still need to maintain separate finances from your LLC to preserve liability shields.

LLC formation also enables greater ownership flexibility and continuity provisions than operating as an individual. While forming an LLC does not directly affect taxes, pairing it with S-Corp election minimizes self-employment taxes at higher incomes.

It is also important to consider that there are costs involved with setting up and maintaining an LLC. Is your venture a serious business with significant income potential, or more of a casual pursuit? Be sure to factor this into your decision as this will help you determine if the benefits of an LLC outweigh the costs.

Disclaimer: The knowledge and perspectives I share simply come from my own experience and should not substitute legal or tax guidance. There are state and individual situation dependent factors that should be considered. You should always consult qualified legal counsel and tax professionals for personalized advice based on specific needs and circumstances before making any major business decisions or tax filing choices.