Before you create a startup or reorganize an existing business, you will need to understand the differences between two prime legal entities: S-Corporations and Limited Liability Companies. While each structure will have its pros and cons, choosing the right one will put your business in a better position for success. Be sure to work with a trusted attorney and accountant as you determine which business entity is right for you.
Understanding S-Corporations (S-Corp)
An S-Corporation (S-Corp) consists of a business that has shareholders. The shareholders will enjoy personal liability protection from the acts (or omissions) of the corporation. It is important to note that there are certain restrictions regarding ownership within an S-Corp. For example, this type of corporation can only have 100 or less shareholders whom are comprised of non-foreign individuals and qualifying estates or trusts.
This type of legal entity is ideal for a company that isn’t interested in publicly raising a large amount of capital. In this vein, the federal government does not place a corporate income tax on S-Corps. However, some states will impose state-level taxes on S-Corp profits. It is important to note that shareholders will have to pay taxes on the distribution of S-Corps profits, as well as any wages that are received.
Advantages vs. Disadvantages of S-Corp
In order to decide whether the S-Corp is right your startup, or the restructuring of your company, it is important that you understand the key pros and cons of selecting this particular legal structure.
- Pro: Taxation — Unlike other corporate structures, S-Corps avoid double taxation since only the individual shareholders are taxed at their personal income levels. Profit distributions are treated as passive income, which means that they are not subject to a self-employment tax. Avoiding a self-employment tax can translate into huge savings for businesses using S-Corps structures.
- Pro: Separation — Through its structure an S-Corp provides additional separation between the owners and the company. This separation is favorably looked upon by banks and other financial investors, and, is especially helpful for any business that seeks fast growth or additional funding.
- Con: Flexibility — One downside of the S-Corps lies in its lack of flexibility. For example, there is only one class of stock and there are restrictions on who can become a shareholder. Additionally, owners are not able to distribute the losses, profits, or voting rights at their discretion. Instead, owners must receive profit distributions in accordance with their percentage of interest in the corporation.
- Con: Fringe Benefits — Unfortunately S-Corps do not provide many tax-free fringe benefits. The lack of tax-free fringe benefits is particularly detrimental when it comes to any accident or health insurance premiums that are paid or reimbursed by the S-Corps. The latter payments are considered taxable compensation for shareholders owning more than two percent of the corporation. In short, S-Corps can’t deduct the costs of employee fringe benefits.
- Con: Initial Startup Costs — Generally speaking, an S-Corp typically costs more to form than an LLC.
- Con: Strict Requirements — S-Corp shareholders must be careful to follow all of the corporation’s requirements. If shareholders do not adhere to the requirements, then they risk disallowing the S-Corp election and subsequently causing the corporation to be treated as a C-Corp.
- Con: Passive income limitation — S-Corps limit the percentage of gross receipts that can be obtained from passive activities. This limitation is set to no more than 25 percent. Passive activities include Real Estate investments.
Understanding Limited Liability Company (LLC)
A Limited Liability Company (LLC) is an organized partnership that offers similar protections to corporations with increased flexibility. The owners of an LLC are called members and each member owns a set percentage of the LLC. The flexibility of the ownership structure allows LLCs to have different membership interests, which means that members can be comprised of individuals, corporations, or other LLCs. It is important to note that an LLC is typically member-managed; however, there are instances where an outside manager is appointed. Additionally, members can only be held financially accountable for the amount of monies that they contribute. For example, if a member contributes $20,000, and a $21,000 debt is incurred, then the member can only be held financially accountable for the initial $20,000 contribution. To use industry jargon, this means that your LLC’s creditors typically can’t “pierce the corporate veil.”
One of the biggest differences between an LLC and the S-Corp occurs in the taxation of profits and losses. Any profits or losses that are incurred are “passed through” to members; as a direct result, entity level income tax is not achieved. Like S-Corps, LLCs avoid double taxation. Members report any income generated on their individual returns. Finally, an LLC is often referred to as a “check the box” entity. This layman’s term means that the LLC may elect to be taxed as either a S-Corp or a partnership.
Advantages vs. Disadvantages of LLC
As with any business structure, there are distinct advantages and disadvantages to an LLC.
- Pro: Flexibility — When compared to an S-Corp, an LLC offers increased flexibility. This flexibility is best realized through the terms of allocation that are associated with the profits and losses of its members. More specifically, the LLC can elect to allocate profits or losses amongst its members. The latter allocation minimizes the overall tax burden that members might experience.
- Pro: Transferability — The beauty of an LLC is that members can limit the transfer of membership interest to simply a transfer of only economic interest. The latter transfer means that future members could be restricted to receiving distributions without any of the accompanying voting or management rights that the original members enjoy. This strategy is particularly helpful for businesses that wish to grow without diluting the voting power of the founding members.
- Pro: Fiduciary Duties — Members of an LLC can’t eliminate or reduce fiduciary duties (with the exception of a few states); however, they can, within reason, decide the standards that are used to measure these duties. Members can determine what activities do not violate fiduciary duties, as well as the approval procedure. In contrast, a corporation has directors and officers who will owe fiduciary duties to both the corporation and its shareholders.
- Pro: Asset Protection — The members of an LLC are protected if a creditor attempts to seize the partner’s interest in the LLC. In the latter instance, a creditor of a partner will only be able to obtain a “charging order.” The “charging order” is placed against the partner’s economic interest, which means that the creditor will not be able to obtain the rights of the partner. This clause is particularly important because it protects the entire LLC from being dismantled by a partner’s creditor.
- Pro: Startup Funds — One of the reasons that LLCs are so popular amongst startups is that they don’t require extensive funds. Typically, an LLC will only require a few hundred dollars to start.
- Con: Taxation — The members of an LLC must pay self-employment tax that is based on the profits, losses, and other compensation for services that are completed by the LLC. This is a direct contrast to S-Corps where self-employment taxes must be paid on only the wages received by shareholder employees and not on any distributions that are issued. In this vein, when compared to an S-Corp, an LLC’s shareholders often receive reduced tax savings. Finally, the IRS will treat each LLC member as if they have been given their entire distribution share (regardless of whether this is the case or not). Thus, even if LLC members chose to leave profits in the LLC, they will still be held liable for income tax on their share of the profits. The only plus side to taxation within an LLC is that members can elect to have the entire entity taxed as an S-Corp, while still retaining the LLC structure. However, this classification is subject to stringent rules and requirements that must be met.
- Con: Fringe Benefits — Like S-Corps, LLCs will be taxed on any payments made towards fringe benefits, such as insurance premiums. Additionally, LLCs must not become “shells;” they must be active entities.
The Bottom Line: What Is Right For You?
As you’ve probably gathered, determining whether a LLC or S-Corp is right for your startup or business is a tricky task. After reviewing the above information, you should sit down with your attorney and accountant to discuss state-specific implications that might influence your decision. In addition, you should answer the following questions:
- Do you anticipate publicly funding your business in the future?
- What is the purpose of your business (i.e. what type of business do you have)?
- How quickly do you plan on growing your business?
- Do you plan on seeking multiple investors?
- Does your business have disposable cash?
- What type of financial investment can you make to form either a LLC or S-Corp?
Answering the above questions will help your attorney and accountant to better determine whether a LLC or S-Corp is best suited for you business. As a final consideration, it is important to note that you can always change from a LLC to a S-Corp (and vice versa) if your business needs to adjust its structure in the future.