If you’re starting a small food business, you’re probably considering different business entity types and trying to decide which is right for you. Limited liability companies (LLCs) are a great option, but you may also have heard that an S Corp can be beneficial.
An S Corp is not actually a business entity – it’s a tax classification that can be chosen by an LLC or a C Corporation. So, if you form an LLC, the decision to make is whether or not to choose S Corp tax status.
In this guide, you’ll learn about the similarities and differences between an LLC and an LLC with S Corp status.
An LLC Defined
An LLC is a business entity that’s regarded as a separate entity from its members and can thus have its own assets and debts. This means that LLC owners, called members, are not liable personally for the obligations of the company.
LLCs also offer pass-through taxation. If an LLC has only one member, it is taxed as a sole proprietorship, so the profits or losses of the LLC pass through to the single member to be reported on their personal tax return. The LLC itself is not taxed.
If the LLC has two members or more, it’s taxed as a partnership, and profits and losses pass through to the members based on their ownership percentages. The LLC itself, again, is not taxed. However, the LLC must file a partnership tax return, but it’s for informational purposes only.
LLCs also offer significant management flexibility. You can essentially manage the LLC any way that you want, without the requirements that come with a corporation.
You can find detailed information about LLCs here.
Watch this video by Marketing Food Online to learn more about how to incorporate your small food business as an LLC:
S Corp Status Defined
An LLC can file an election to be taxed as an S Corp by meeting certain requirements and filing Form 2553 with the IRS. The requirements for S Corp status are:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates
- Cannot be partnerships, corporations, or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. some specific financial institutions, insurance companies, and domestic international sales corporations).
Starting a legal business as an LLC essentially means that the LLC can have no more than 100 members and no members can be a partnership, corporation, or a non-resident alien.
With S Corp status, the company must meet certain corporate requirements, such as having a board of directors and holding regular shareholder meetings that are recorded in the company’s records. The S Corp must also appoint officers, such as a Chief Executive Officer (CEO) and a Chief Financial Officer (CFO).
An S Corp differs from a C Corp in that an S Corp has to pass through taxation, just like an LLC without S Corp status. However, S Corp owners who are active in the business must be paid a reasonable salary as defined by the IRS before they can take distributions, which for S Corps are called dividends, from the company.
Watch this video by Mark J Kohler to learn more about S Corp:
Key Differences Between an LLC and an S Corp
An LLC and an S Corp have three key differences.
As mentioned, LLCs have much management flexibility with few legal requirements, while an S Corp is subject to the requirements of a corporation including having a board of directors.
The ownership of the members of an LLC is expressed in percentages. For example, an LLC with two owners may allocate 50% ownership to each member. With S Corp status, ownership is expressed in shares, which can be sold or transferred.
As mentioned, both an LLC and an S Corp offer pass-through taxation, meaning that profits and losses are passed through to members to be reported on Schedule C of their personal tax returns.
However, LLC members are subject to self-employment taxes that fund Medicare and Social Security, and a total of 15.3%.
In an S-Corp, the profits of the company are not subject to self-employment taxes. However, as mentioned, the owners that are actively involved in managing the company must be paid a reasonable salary before taking any distributions of the company. That salary will be paid just like any salary would be paid and is subject to payroll taxes, which fund Medicare and Social Security.
What this means, in a nutshell, is that S Corp owners only pay Social Security and Medicare taxes on their salaries, not on the profits of the company. This can mean a significant tax saving.
Watch this video by LYFE Accounting to understand the difference between the two:
So, Which Is Right for Your Small Food Business?
Whether an LLC or an S Corp status is right for you essentially depends on how much your business is earning and the tax factors that are specific to you.
An S Corp status comes with additional costs from the corporate requirements and the payroll expenses of manager salaries. However, as discussed, it can provide significant tax savings.
So, for an S Corp status to be beneficial, the tax savings must be greater than the additional costs of the corporate requirements and payroll. These calculations are complex and are best done with the help of your tax advisor.
Now, here’s a caveat. If you plan to grow your small food business by raising money from investors, an S Corp status may be better for you regardless of the financial advantages or disadvantages. This is because the owner of an S Corp since it’s measured in shares rather than percentages like an LLC is much easier to transfer to investors for the capital they provide. That makes S Corps much more attractive to investors than LLCs.
In general, LLCs are a good choice for small food businesses that are just starting out and don’t have a lot of employees or complex ownership structures. They are also a good choice for businesses that want to maintain flexibility in terms of management and tax treatment. S Corps, on the other hand, may be a better choice for businesses that are looking to take on investors and raise capital, or for businesses that are generating a significant amount of income and want to take advantage of the potential tax benefits.
So to make the decision about your company’s tax status, it’s best to speak with both your tax advisor and your attorney to discuss your situation and goals. Those professionals can help you make an informed decision based on all factors.
In summary, LLCs can elect to be taxed as S Corps if it’s deemed beneficial to do so. The decision is complex, so it’s best made with the help of professionals. Electing S Corp status is not difficult once you’ve made the decision but give it careful consideration before you do so.