In this episode we touch on the complex topic of the benefits of an S-Corp vs. an LLC business structure. The differences, misconceptions, and benefits are discussed while hitting on some new topics you might not have known about. We talk about the importance of educating yourself and finding advisors that can assist you in making these pivotal decisions.
What we cover in this episode:
- 02:15 – Establishing an Advisor
- 03:59 – What is an LLC?
- 11:15 – What is an S-Corp
- 18:37 – Multi-Member LLC
- 22:05 – Your Basis
Establishing an Advisor
Establishing relationships with professional advisors to help educate you through building the foundation and structure of your business is one of the first important steps to take as you begin operating. Determining how you will handle the legalities of your business is something that needs to be worked out by yourself and any partners with whom you are in agreement.
Being prepared when trouble arises is important whether you are an LLC or an S-Corp. CPAs and attorneys can help you from a legal perspective, taxation perspective, and business perspective.
Some great advice is to be proactive rather than reactive to the legal structure of your business. Educate yourself as much as possible first before seeking out advisors. This way you are able to find professionals who understand what you want and need from their services. Remember, Knowledge is Power…when applied.
What is an LLC?
An LLC is a legal business structure that stands for limited liability company. There are two types of LLCs that you can elect which are multi-member and sole proprietor, or single-member LLC. What it all comes down to, no matter what you elect, is the bigger legal picture and your long-term goals. A sole proprietor of course is just yourself and a multi-member is any business that includes yourself and others.
If you elect a sole member or sole proprietor LLC, your taxes will be different from a multi-member. This also depends on which state you are in since some states don’t require a return for your LLC. A benefit of being a sole member LLC is that your LLC protects your personal assets from your business, even when it comes to taxes.
The other type of LLC is the multi-member LLC which consists of two or more members. Taxes are also different if it is a multi-member LLC depending on the state. These can get very complex, which is why if you are a for-profit business, it would be in your best interest to speak with a CPA and lawyer. Complex issues can arise when it comes to business planning and goals, as well as tax issues and future growth.
One of the biggest misconceptions when deciding upon an LLC is the legal recognition it receives. An LLC is not recognized at the federal level, but only the state level. This is because laws for legal protection typically vary from state to state.
One benefit of an LLC is the fact it is convertible. If your business is seeing great growth or your plans change down the line, you are able to convert it to an S-Corporation. Of course this is something you should consult with your attorney about before making the election. Depending on your business goals and expansion ideas, you may find the benefits of an S-Corp outweigh the LLC.
What are the benefits of an S-Corp vs an LLC?
The benefits of an S-Corp versus an LLC may be a better fit for your business goals when it comes to your state and considering your tax situation. Planning out what you want for the future of your business can lay the map for deciding whether to be an S-Corp or not. Unlike an LLC, an S-Corp is federally recognized, basically being a taxation election. Remember, an LLC has more legal protection but doesn’t do much when it comes to the IRS.
If you want to take your business international, or national, right out of the gate, electing S-Corp status may be the best structure for you. If you start off with an LLC, the great thing is you can convert as long as you make sure it is the right time to do so.
There can be penalties with converting to an S-Corporation and then defaulting back, so you want to make sure you sit down with your legal counsel and they run through all your options. An advisor like a CPA or CFO can also help you with other monetary rules such as a basis.
Have you heard of basis? Your basis is a big deal, especially in an S-Corp.Of course you will need money to start up your business no matter the business structure you choose. Where and how you get this money does play a great role in your finances. This is another reason it is very important to have the right people on your team to advise in situations like we outline below.
Example #1: Funding Your Business Yourself
Let’s say you go get a second mortgage on your house and you fund your business yourself with your own personal money. Money directly from you increases your basis in your business. If you put $50,000 of your own funded money into your business, you have a $50,000 basis. Now, let’s say your business has a $25,000 loss. You now have a $25,000 basis. This basis allows you to reduce your taxable income by $25,000. This allows you to take the $25,000 loss since your basis exceeds the loss.
Example #2: Funding Your Business with a Loan
Now, let’s say you have a family member who wants to fund the $50,000 to your business. Because you are not funding your business directly, you are now starting with no basis. In the case of a $25,000 loss, like above, this could potentially change the situation regarding whether you’re able to reduce your taxable income, depending on your business structure. The funding would have to be lended to you, then to the business to increase your basis. If the loan comes directly from the family member into the business, your basis does not increase.
Basis and How it Impacts Each Example Provided
These two simplified scenarios relate back to the LLC vs S corp. Basis comes into play when you become an S Corp. As an LLC, you could claim a loss in both situations (with no other considerations in this boiled down example). On the other hand, as an S Corp, you can claim the loss in the first scenario but not in the second, because the money didn’t go directly through you, instead it went directly to your business. As an S Corp, you would have to structure the debt to come directly from you into the business, rather than from your family member. This is a perfect example of a complex matter that you could benefit from if you consult an advisor before and during your business process.
Determining the benefits of an LLCs and S-Corporations and which one is the best for you will save time and money in the long run. Creating a strategic plan, outlining your business goals can help generate questions and conversations needed to decide which business structure is best for everyone involved.
Once again, we want to make sure you understand how important it is to seek out and speak with an advisor before launching your business. Finding a lawyer and CPA early on will help with concerns you may have when state regulations, federal regulations, taxes, and employees start entering the picture.