When you start on your startup journey, determining the ideal business structure can make or break your success. You may be asking yourself several questions, such as:
Which is better a limited liability company (LLC) or a Subchapter S Corporation (an S-Corp)?
Can an S-Corp own an LLC?
Which entity pays less taxes, an LLC or an S-Corp?
Is an S-Corp better for self-employment taxes?
Though both LLCs and S-corporations offer liability protection, S-corps may provide additional tax benefits. Let's face it, we want to pay as little self-employment taxes as possible (as little as legally possible that is). Investors may be reluctant to invest in your S-Corp though. So, is there a way to have the best of both an LLC and an S-Corp? With various factors to weigh from taxation to liability limitations, selecting the optimal framework requires research and forethought.
This blog post explores whether combining an S-Corp and LLC offers startups the best of both worlds in terms of taxes and legal protections. We'll examine the implications of an S-corp owning an LLC, from pass-through taxation to liability risks. Read on for guidance to make an informed decision when establishing your entity and maximize advantages as you try to get traction in your business.
LLC vs S-Corp: Key Differences Between Business Structures
Taxation
Both an S-corp or an LLC pass income and losses to shareholders, who then report them on their personal tax returns. An LLC can choose to be taxed as a sole proprietorship, partnership, or corporation (although you should discuss this with one of our tax attorneys, before making this election). Most LLCs elect to be taxed as partnerships, passing income and losses to members (through a Schedule C). S-corps typically offer more favorable tax treatment, from the perspective of self-employment taxes), as business profits are only taxed once at the individual level (not when distributions are made).
Ownership
This is one of the areas where an LLC is usually better than an S-Corp. S-Corps can only have up to 100 shareholders, all of whom must be individuals who are U.S. citizens or residents (meaning no foreign owners). LLCs have no restrictions on the number or type of members (so you can have foreign owners, as well as entity ownership). S-corps also have more restrictions on who can own shares, prohibiting most trusts, corporations, and partnerships from being shareholders. LLCs have much more flexibility in ownership and membership.
Management Structure
S-corps must have a board of directors and corporate officers. LLCs have more flexibility and can be member-managed or have a managerial structure. The less rigid structure of an LLC may be better suited for small, closely-held businesses. However, the corporate formalities required of an S-corp may provide more clarity and help mitigate liability risks.
Profit Distribution
Both S-corps and LLCs allow flexibility in allocating profits and losses among owners. However, S-corps require pro-rata distribution of profits, while LLCs can distribute profits disproportionately. The flexibility of an LLC may be advantageous for certain business structures where disproportionate distributions are desired.
In summary, while an S-corp and LLC share some similarities, there are key differences in taxation, ownership, management, and profit distribution that must be considered based on your specific business needs. Consulting with legal and tax professionals can help determine which structure is right for your startup.
Can an S-Corp Own an LLC?
Yes, an S-corporation can own an LLC. However, there are tax implications to consider with this business structure.
Ownership and Control
An S-corp can own an LLC as a subsidiary, with the S-corp maintaining full ownership and control over the LLC. The S-corp issues shares to its shareholders, who then elect directors and officers to manage the company. The S-corp's directors and officers will also govern the LLC subsidiary.
Tax Treatment
For tax purposes, the LLC subsidiary will be treated as a disregarded entity by default. This means the LLC's income and losses will flow through to the S-corp parent company. The S-corp will report the LLC's income and losses on its own tax return. The S-corp's shareholders will then report their allocated share of the combined income and losses on their personal tax returns.
However, the S-corp can elect to treat the LLC as a corporation for tax purposes instead. In that case, the LLC would file its own corporate tax return and pay taxes at the entity level. The LLC's after-tax income would then flow through to the S-corp parent. This structure avoids double taxation but may result in a higher total tax liability.
Liability Protection
An S-corp's liability protection does not extend to its subsidiary LLC. However, the LLC provides liability protection to its members (in this case, the S-corp). So, the S-corp's shareholders would not be personally liable for the LLC's debts and liabilities. But, the S-corp's assets could be at risk for the LLC's liabilities. Proper capitalization and insurance are important to mitigate these risks.
In summary, an S-corporation can own an LLC subsidiary, but business owners must weigh the tax and liability implications carefully based on their unique situation. With prudent planning, this structure can provide significant benefits for startup companies.
Tax Benefits of Using an LLC With an S-Corp
Forming an LLC owned by an S-corporation provides several tax advantages for startups. As pass-through entities, LLCs and S-corps allow business income and losses to pass through to owners’ personal tax returns. This avoids the double taxation of C-corporations.
Pass-Through Taxation
Income and losses from an LLC owned by an S-corp pass through to shareholders’ personal tax returns. The business itself does not pay income taxes. This can lower the overall tax burden, especially in early years when startups are generating losses. Pass-through taxation also avoids the complex tax reporting requirements of C-corps.
Flexibility in Allocating Profits and Losses
An S-corp can allocate income, losses, and distributions among shareholders according to ownership interests. This flexibility allows startups to allocate more losses to shareholders in higher tax brackets to maximize tax savings. Owners can then allocate more income to themselves in later profitable years.
Avoiding SE Tax on Distributions
As an S-corp, business profits distributed as dividends to owners are not subject to self-employment (SE) tax. SE tax is 15.3% on the first $128,400 of income for 2020. Distributing profits as dividends rather than salaries can save up to $19,999 per owner in SE tax. However, the IRS requires S-corps to pay owners “reasonable compensation” as salary before distributing dividends. Salary amounts must match typical compensation for the work performed.
Simpler Than Partnerships
An S-corp/LLC structure is simpler than a partnership for tax purposes. S-corps require only 1 tax return filed at the entity level. Partnerships require returns and schedules to be filed for both the partnership and individual partners. The S-corp/LLC structure reduces administrative burden, which is valuable for startups.
In summary, the combined S-corporation and LLC structure provides substantial tax benefits for startups through pass-through taxation, flexibility in allocating income and losses, avoiding SE tax on distributions, and simpler taxes than partnerships. With strategic planning, these benefits can save startups thousands per year in taxes.
Setting Up a Single Member S-Corp With an LLC Subsidiary
Establishing a single-member S corporation with an LLC subsidiary provides significant tax advantages for startup businesses. As the sole owner of an S corporation, you are considered an employee and can receive a reasonable salary, with the remaining profits distributed as dividends. The dividends are taxed at a lower personal income tax rate.
Creating the S Corporation
To form an S corporation, you must first establish a C corporation and then file IRS Form 2553 to elect S corporation status. This election allows the S corporation to act as a pass-through entity, meaning the profits and losses are passed through to your personal tax return. You should file articles of incorporation with your state and adopt corporate bylaws. Appoint yourself as the director and issue shares of stock to yourself.
Establishing the LLC Subsidiary
Once you have formed the S corporation, you can create an LLC subsidiary. The S corporation will be the sole member of the LLC. File articles of organization with your state to establish the LLC. As the sole member of the LLC, the S corporation controls 100% of the membership interests. The profits and losses of the LLC will pass through to the S corporation and then to your personal tax return.
Maintaining the Structure
To properly maintain this structure, you must observe all corporate formalities for the S corporation like holding an annual meeting of shareholders and directors, keeping minutes of meetings, and issuing an annual report. You must also file separate tax returns for the S corporation and LLC, in addition to your personal return. The S corporation and LLC should have their own bank accounts and accounting books.
This structure provides legal liability protection for your personal assets through the S corporation and LLC. The pass-through taxation of the S corporation and LLC allows for significant tax savings compared to a standard C corporation. With prudent planning and proper implementation, an S corporation with an LLC subsidiary can be an excellent choice for your startup business.
LLC and S-Corp FAQs: Can an S Corporation Own an LLC?
An S corporation can own an LLC, but there are tax considerations to keep in mind. When an S corporation owns an LLC, the LLC is treated as a qualified subchapter S subsidiary (QSUB) for tax purposes. This means the LLC's income, losses, and other tax attributes pass through to the S corporation's shareholders.
Ownership Requirements
For an LLC to qualify as a QSUB, the S corporation must own 100% of the LLC's ownership interests. If the S corporation owns less than 100% of the LLC, the LLC will be treated as a separate entity for tax purposes. The S corporation will have to report the LLC's income or loss on its own tax return based on its percentage of ownership.
Tax Treatment
When an S corporation owns 100% of an LLC, the LLC is disregarded for tax purposes. Its income and losses are reported on the S corporation's tax return and passed through to shareholders. The S corporation must meet the qualification requirements to maintain its S corporation status, including limits on the number and type of shareholders. The LLC does not file its own partnership or corporate tax return.
State Requirements
Some states do not recognize the federal QSUB rules. In these states, the LLC may still need to file a separate state tax return and pay state taxes or fees. The S corporation will have to report the LLC's state tax liability and any state taxes paid on its own state tax return. Check with your state's tax rules regarding QSUB treatment.
Overall, an S corporation can own an LLC, but the tax treatment depends on following the ownership and qualification rules for QSUB status. When set up properly, an LLC owned entirely by an S corporation can provide some liability protection while also taking advantage of the pass-through taxation of an S corporation. However, state rules may require additional filings or payments, so you should understand the requirements in your particular state.
Conclusion
As a startup founder, determining the best tax structure for your business requires weighing considerations like liability protection, taxation rules, and ease of setup and administration. While an S-corporation and LLC each have advantages, combining them through an S-corp parent owning an LLC subsidiary can provide the liability shield of an LLC with the taxation benefits of an S-corp. Just be sure to consult legal and tax experts when making these structural decisions, as the implications can be complex. With the right business structure in place, you’ll be positioned to minimize taxes and legal risks as your startup grows. Careful planning now allows you to focus energy on your business mission.
If you need professional legal assistance, please contact us. We're here to help.
Hozzászólások