If your goal is to limit liability of your business and deduct business losses from your non-business income, your choices for a business entity basically boil down to a New York limited liability company (LLC) or an S corporation (which is a New York corporation that has elected pass-through tax treatment by filing Form 2553 with the IRS).
Despite the hype over the relatively new LLC, many small businesses still prefer to become an S corporation when it comes to choosing an entity for their venture. Why?
Even though each situation is unique, these small business owners probably like the fact that:
Everybody is more familiar with the corporate form
LLCs are a new type of entity and everybody is still going through a learning curve. Many people, including accountants and lawyers, like to stay on familiar grounds.
Owners of an S corporation may save on self employment taxes
Any individual who carries on a trade or business and derives income from it has to pay self-employment tax on the income in the amount of 15.3%. An S corporation (unlike an LLC) can declare certain income as salary to the owner (subject to self-employment tax) and certain income as profits distributed to the owner (not subject to self-employment taxes). However, the allocations of salary to distribution have to be reasonable.
An S corporation is cheaper to form than an LLC
In New York it is cheaper to form a corporation ($125 filing fee) than to form an LLC ($200). In addition, an LLC is required to publish its formation in public newspapers which adds additional cost of about $1000.
I am not saying that the above reasons warrant the choice of an S corporation, because too many factors go into the choice of an entity. I simply noticed that many small businesses are still carried on as S corporations and was wondering why. After some talking to accountants and small business owners, I came up with the above reasons.
However, before you make the decision to go with the famliar S corporation, be clear about the following limitations of S corporations:
- Shareholders of an S corporation must be U.S. residents or U.S. citizens;
- S corporations cannot have more than 100 shareholders;
- S corporations can only have one class of stock, i.e. all shareholders must have the same rights when it comes to profits and losses of the corporation (this is often disliked by potential investors);
- the possibilities for deductions of entity losses on the shareholder level are more limited than in an LLC;
- A conversion of an S corporation to an LLC may have negative tax consequences, whereas a conversion from an LLC to a corporation is likely tax neutral.
Finally, I said it before, choice of entity is not an easy subject and
deserves to be discussed with your accountant and/or small business
attorney.
See the tax law governing s corporations in subchapter s of Title 26 of the United States Code.
