Investment Risk: S Corp's Llc Investment Explained

Investing is a great way to build personal wealth, but it also comes with financial risks. One way to protect your personal assets and limit liability is by setting up a limited liability company (LLC). An LLC is a flexible business structure that allows you to pool money from multiple investors and invest in various assets, including stocks, bonds, real estate, and other businesses. It also offers tax benefits, such as pass-through taxation, where the LLC members pay taxes on the business income instead of the entity itself. However, investing through an LLC may not always result in tax savings, and the tax rate depends on the income generated. On the other hand, S-corps have additional tax advantages, allowing members to retain more profits and save on taxes. While both LLCs and S-corps offer liability protection for investors, there are differences in how investments are structured and potential tax implications. Understanding these nuances is crucial before deciding on the best structure for your investment strategy.

Pros and cons of an S corp

An S corporation, or S corp, is a specific type of corporation that draws its name from and is governed by Subchapter S of the Internal Revenue Code. S corps are often chosen by small business owners for the tax advantages and liability protection they offer.

Pros of an S corp

• Pass-through taxation: S corps are considered "pass-through" entities for tax purposes, meaning that business income, losses, and deductions are passed through to the owners and taxed at their individual income tax rates. This avoids double taxation, which occurs with C corporations.
• Limited liability protection: S corps provide a layer of protection for owners' personal assets. If the company is sued or incurs debts, only the business assets are at risk.
• Enhanced credibility: The complex process of setting up an S corp lends credibility to the business, signalling to potential customers and investors that it is legitimate and stable.
• Perpetual existence: S corps can continue to exist indefinitely, even if the owner passes away or leaves the company. This makes it easier to transfer ownership in the future.
• Ease of ownership transfer: S corp shareholders can easily transfer their ownership interests without the lengthy and expensive process required by other business entities.
• Flexible accounting methods: S corps allow business owners to choose their accounting methods, providing them with enhanced flexibility.
• Avoid self-employment taxes: Owners of an S corp are considered employees, not owners, and therefore do not have to pay self-employment taxes.

Cons of an S corp

• Strict requirements and regulations: S corps are subject to more stringent regulations and have restrictions on ownership, including a limit of 100 shareholders, who must be U.S. citizens or resident aliens.
• Reasonable compensation: Shareholders who work for the S corp must pay themselves a "reasonable compensation" that aligns with fair market value. If the IRS deems compensation inadequate, they can reclassify earnings and wages, resulting in additional tax liabilities.
• Increased IRS scrutiny: Due to their advantageous tax status, S corps are often under closer scrutiny by the IRS, particularly regarding salary payments and dividends.
• Potential tax liabilities: Owners must pay themselves a reasonable salary for their services, and setting the salary too low to avoid self-employment tax can raise red flags with the IRS.
• Rigid profit and loss allocation: S corps are required to allocate profits and losses based strictly on the percentage of ownership or number of shares held, whereas other entities like LLCs have more flexibility.

Pros and cons of an LLC

A Limited Liability Company (LLC) is a hybrid business structure that combines the features of corporations and partnerships. It provides limited liability like a corporation, but with the tax benefits of a partnership.

Pros of an LLC

• Protection of personal assets: LLCs offer a protective barrier between your business and private resources. This means that members' personal wealth is protected in the event of financial or legal complications.
• Tax benefits: LLCs are subject to pass-through taxation, meaning profits and losses are taxed according to each member's personal income tax rate, preventing double taxation.
• Management flexibility: LLCs can be member-managed or manager-managed, and members can be actively involved in the business without jeopardising the liability protection.
• Ease of formation: LLCs are generally quicker and simpler to establish than corporations, with less paperwork and fewer bureaucratic hurdles.
• Credibility: LLCs offer significant credibility to potential investors, clients, and partners.

Cons of an LLC

• Raising capital: LLCs cannot issue stock like corporations, making it more challenging to attract investment capital and major investors.
• Taxation on profits: Members of an LLC must pay taxes on their share of profits every year, regardless of whether those profits are distributed.
• Self-employment taxes: Members of an LLC are considered self-employed and must pay self-employment taxes for federal services such as Social Security and Medicare.
• Complexity in ownership transfer: There may be complexities in transferring ownership, as the life of an LLC is often limited by the tenure of its members.
• Higher fees: LLCs typically have higher fees than sole proprietorships or general partnerships.
• Legal uncertainties: As LLCs are a relatively new business structure, there is a lack of legal precedent, which can create uncertainties around meeting corporate formalities and maintaining limited liability protection.

Tax implications of an S corp

S corporations, or S corps, are considered "pass-through entities" by the IRS. This means that any deductions, losses, income, credits, and profits are passed directly to shareholders, who then report their share of the business's performance on their own personal tax returns. The tax rate paid by the owner/shareholder on S corp profits is determined by their individual income tax rate, which can be anywhere from 10% to 37%, depending on the filer's total taxable income.

One of the biggest tax advantages of the S corp business structure is that it avoids double taxation. This means that S corps don't have to pay taxes at the federal level, unlike C corps. Instead, S corp profits are only taxed once, on the personal tax returns of individual shareholders. Shareholders who incur out-of-pocket expenses related to the business cannot deduct them on their tax return. Instead, they must submit an expense claim form to the S corp, which will then pay the shareholder back.

S corps are required to file their annual tax return by the 15th day of the third month after the end of the tax year. For 2024, S corp taxes are due on March 15, 2024. Extension requests are also due on this date and can be made using IRS Form 7004.

To file taxes, S corps use two main forms: IRS Form 1120-S, the U.S. Income Tax Return for an S Corporation, and Schedule K-1 (Form 1065). Form 1120-S is used to report income, losses, credits, and deductions, as well as employee wages, officer compensation, and any other information related to business income and expenses. Filing Form 1120-S automatically generates a Schedule K-1 form for each individual shareholder/partner. The S corp must then supply a completed Schedule K-1 form to each individual shareholder indicating their portion of any income, losses, credits, or deductions.

In addition, the business owner of an S corp is required to pay themselves a W-2 salary (with taxes withheld), which is reported as income on the S corp owner's IRS Form 1040. Shareholders (including the S corp owner) report income distributions and business losses via Schedule E of Form 1040.

S corps enjoy several tax advantages, including pass-through status, employee income advantage, loss deductions, self-employment tax relief, and healthcare insurance deductions.

Tax implications of an LLC

An LLC, or limited liability company, is a business entity registered under state law to offer limited liability protection to its owners or members. It is not a business structure recognised by the IRS for federal income tax purposes, so you have to choose how your LLC will be taxed.

LLCs are considered "pass-through entities", meaning the LLC itself does not pay federal income taxes on business income. Instead, the income "passes through" to individual members of the LLC, who pay federal income tax on their share of the LLC's profits via their own individual tax returns. This is how LLCs avoid double taxation, which is when profits are taxed at both the federal and individual level.

There are four options for how an LLC can pay federal taxes: sole proprietorship, partnership, C Corporation, or S Corporation.

If your LLC has just one member, it will be taxed as a sole proprietorship by default. This is known as a “disregarded entity”, where the LLC does not pay taxes separately from its owner. The single member files taxes on the amount they earned each year, using Schedule C, part of the individual tax return Form 1040.

If your LLC has multiple members, it will be taxed as a partnership by default. Like a sole proprietorship, LLC partnership taxes pass through the entity to the business owners. You must file IRS Form 1065 with the IRS on behalf of the LLC annually by March 15, and then a Schedule K-1 is issued to each member to report their portions of the annual profits and losses from the business on their individual income tax returns.

You can also choose to have your LLC taxed as a corporation, using Form 1120: Corporation Income Tax Return (or Form 1120S if taxed as an S-Corporation).

If you choose to be taxed as a C-Corporation, your LLC will be subject to double taxation. The company's net income will be taxed first at the corporate level and then again when the after-tax profits are distributed to shareholders as dividends.

If you choose to be taxed as an S-Corporation, your LLC becomes a pass-through entity, avoiding double taxation. Taxes on income from an S-Corporation are assessed at the owners' individual rates.

No matter which option you choose, your LLC operating agreement should have a provision for taxation. If you ever decide to change and utilise a different tax classification, the operating agreement must be amended.

Eligibility for S corp status

To qualify for S-corporation status, a corporation or LLC must meet the following requirements:

• The business must be a domestic corporation.
• Shareholders can only be individuals, certain trusts, estates, and certain exempt organizations (e.g. a 501(c)(3) non-profit). Shareholders cannot be partnerships, corporations, or non-resident aliens.
• The business must have no more than 100 shareholders.
• The business must only have one class of stock.
• The business must not be an "ineligible corporation", such as an insurance company, a domestic international sales corporation, or a possession corporation.
• All shareholders must consent to the election.

To become an S-corporation, the corporation must submit Form 2553, Election by a Small Business Corporation, signed by all shareholders.

Frequently asked questions