Lawn Mowing Business Tip: S Corp, C Corp or LLC? Which Structure Is Right For You?
When a person considers starting a lawn business, or when existing lawn business owners consider changing their business structure, one of the most common options they evaluate is the corporation.
There are several different types of corporations, the C corporation, the S corporation, and LLC. Which one is best often depends on the goals you have for your lawn business.
Corporations and limited liability companies ("LLC s") are preferred lawn business structures because, unlike sole proprietorships and partnerships, both offer liability protection. This means that the owner of a lawn maintenance company cannot be held personally responsible for the company’s debts. The personal assets of an owner are shielded from company liabilities.
In researching the various business structures, one inevitably comes across the S corporation. S corps and LLC's are similar in that they are both "pass-through" entities for tax purposes. The income of these type of lawn businesses are passed through to their owners and reported on the owners’ personal income tax returns, thereby eliminating the double taxation incurred by owners of a standard lawn care corporation, or C corporation. (With a C corporation, the net business income is subject to corporate income tax, and the monies remaining after the corporate income tax are taxed a second time when they are distributed as dividends to its owners who must then pay personal income tax.)
Let's start with explaining the difference between an S Corp and an LLC? And discuss which structure is right for your lawn care business?
The answer depends on your own unique situation. There really is no other way to say it. If operational ease and flexibility are important to you, an LLC is a good choice.
If you are looking to save on employment tax and your situation warrants it, an S Corp could work for you as the lawn business structure of choice.
Lawn Business Ownership & Operation
There are restrictions on who can be owners (also known as "shareholders") of an S corporation. An S Corp can have no more than 75 shareholders. None of the shareholders can be nonresident aliens. And shareholders cannot be other corporations or LLC s. This is important.
An S Corp is operated in the same way as a traditional C corp. This lawn business structure must follow the same formalities and record keeping procedures. The directors or officers of an S Corp manage the lawn business and an S Corp has no flexibility in how profits are split up amongst its owners.
Let us explain.
The profits must be distributed according to the ratio of stock ownership, even if the owners may otherwise feel it is more equitable to distribute the profits differently.
LLC s offer greater flexibility in ownership and ease of operation. There are no restrictions on the ownership of an LLC . An LLC is simpler to operate because it is not subject to the formalities by which S corps must abide. An LLC can be member-managed, meaning that the owners run the lawn care business. Or it can be manager-managed, with responsibility delegated to managers who may or may not be owners in the LLC . This may be more attractive to your situation. The lawn business owners of an LLC structure can distribute profits in the manner they see fit.
This may be a lot to take so we'll paint you a picture.
Let’s say, for example, you and a partner own an LLC called ANYBODY MOWING LLC. Your partner contributed $50,000 for capital. You only contributed $5,000 but you perform 95% of the work.
The two of you decide that, in the interest of fairness, you will each share the profits 50/50. As an LLC you could do that. If you had your lawn business set up as a S Corp you could only take 10% of the profits while your partner would take the other 90%.
Get it? Let's keep going.
Employment Tax: Savings vs. Paperwork
A major factor that differentiates a lawn business structured as an S Corp from an LLC is the employment tax that is paid on earnings. The owner of an LLC is considered to be self-employed and, as such, must pay a "self-employment tax" which goes toward Social Security and Medicare. The entire net income of the lawn business is subject to this tax at a rate of 15.3% (rate as of this writing).
In an S Corp, only the salary paid to the employee-owner is subject to employment tax. The remaining income that is paid as a distribution is not subject to employment tax under IRS rules.
What does this mean? There is the potential to realize substantial employment tax savings.
Let's say Billy owns a lawn service business. In keeping with the industry standard, Billy decides that a reasonable salary for a lawn business manager is $35,000 and pays himself accordingly. Billy's total earnings for the year are $60,000: $35,000 paid in salary and the remaining $25,000 paid as a distribution from the S Corp . Billy's total employment tax is $5,355 (15.3% of $35,000).
If Billy were the owner of an LLC , he would have to pay employment tax on the entire $60,000, equaling $9,180. But as an S Corp, he realizes savings of $3,825 in employment tax.
Not bad. But, listen up.
One might assume that these savings could be further manipulated by reducing the salary to an extremely low amount and attributing the rest of one’s earnings to distributions, but this would be a very big mistake. In practice, the IRS is careful to notice whether a salary is reasonable by industry standards. If it determines a salary to be unreasonable, the IRS will not hesitate to reclassify distributions as salary. Don't mess with the IRS. It's never worth it.
Still, while the potential employment tax savings may make the S Corp an attractive structure for your lawn care business, bear in mind that you would then have to deal with all the paperwork associated with payroll tax.
The payroll tax is a pay-as-you-go tax that must be paid to the IRS regularly throughout the year. This means on time or you will incur interest and penalties. The paperwork alone can be an overwhelming task for someone who is not familiar with it. If you expect to incur losses or otherwise experience a cash flow crunch during the year that would hinder you from paying the payroll tax when due, this could present a problem.
Owners of LLC's pay their self-employment tax once a year on April 15 when income taxes are normally due (or make quarterly estimated tax payments, if they expect to owe total taxes of $1,000 or more). Income tax filings are also relatively easy for the lawn business owners of an LLC. A single-member LLC files the same 1040 tax return and Schedule C as a sole proprietor. Partners in an LLC file the same 1065 and Schedule C as do owners of traditional partnerships.
Employment/payroll tax on salary; no employment tax on dividends paid to shareholders.
Self-employment tax on total net income.
The C Corporation Vs. S Corp
The C corporation is the standard corporation. The S corporation is a standard corporation that has elected a special tax status with the Internal Revenue Service (IRS). It gets its name because it is defined in Subchapter S of the Internal Revenue Code. In order to elect S corporation status, Form 2553 must be filed with the IRS and all S corporation guidelines met.
While the C corporation and S corporation have many similarities, they also have distinct differences.
Both offer the same limited liability protection for shareholders (owners), meaning that the shareholders are typically not personally responsible for the debts and liabilities of the lawn care business. Both are separate legal entities created by a state filing.
The formation documents that are filed with the state, which are typically called the articles of incorporation or certificate of incorporation, are the same whether the lawn service business will be a C or an S corporation.
To recap a bit, corporations have shareholders, directors and officers. Shareholders are the owners of the company and elect the board of directors. The board of directors oversees and directs the affairs of the corporation and has responsibility for major decisions, but is not responsible for the day-to-day operations of the corporation. The directors elect officers to manage the daily affairs of the business. Most states allow one person to be a shareholder, director and officer of a corporation.
Both are required to follow the same internal and external corporate formalities. Examples of internal formalities include adopting bylaws, issuing stock, holding initial and then annual meetings of shareholders and directors, and keeping the minutes from these meetings with the corporate records. Examples of external requirements include filing annual reports, which are required by the state, and paying the necessary annual fees.
C corporations are separately taxable entities. C corporations file a corporate tax return reporting profits or losses, and any profits are taxed at the corporate level. C corporations face the possibility of double taxation when profits are distributed to shareholders in the form of dividends, as the shareholders must report dividends as personal income and pay tax on them at the individual level.
S corporations are pass-through tax entities. Pass-through taxation is discussed more below.
2. Corporate ownership
C corporations can have an unlimited number of shareholders, while S corporations are restricted to no more than 75 shareholders (some say 100, check with your local CPA or attorney).
C corporations can have non-US residents as shareholders, but S corporations cannot.
S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships, or many trusts. C corporations are not subject to these same restrictions.
S corporations can have only one class of stock (disregarding voting rights). C corporations can have multiple classes of stock.
3. S corporation Election
S corporations must make a timely filing of Form 2553 with the IRS. The IRS instructions indicate this form must be completed and filed:
At any time before the 16th day of the 3rd month of the tax year the election is to take effect, or;
At any time during the tax year preceding the tax year it is to take effect. An election made no later than 2 months and 15 days after the beginning of a tax year that is less than 2½ months long is treated as timely for that year.
An election made after the 15th day of the 3rd month but before the end of the tax year generally is effective for the next tax year. However, an election made after the 15th day of the 3rd month will be accepted as timely filed if the corporation can show that failure to file on time was due to reasonable cause.
As mentioned above, electing S corporation status with the IRS allows for pass-through taxation of the corporation’s profits. S corporations must still file corporate tax returns, but they do not pay taxes at the corporate level. The corporation’s profits are passed-through to the individual tax returns of the shareholders, and taxes are paid on those profits at the individual tax rate. If the corporation is reporting a loss, the loss is passed-through to the shareholders as well. Because S corporations do not pay taxes at the corporate level, this eliminates the potential double tax C corporations face when profits are issued as dividends to shareholders.
How's that for an explanation? ;-)
There is no one, magical entity that works for everyone. A CPA or a specialized tax attorney can assist you in choosing the right structure for your lawn business. The important thing is to consider the operational, legal and tax aspects of each structure as they apply to your unique situation.
Nevertheless, as you determine which business structure is the best for your business, there are both online and professional resources to assist you. For advice on which structure to choose, you should contact an attorney or accountant. For additional information visit NOLO.com.