LLC or S-Corp: Which entity is best for you?
LLC or S-Corp
Which entity is best for you?
When choosing a form of entity, small business owners often end up deciding between an S-Corporation and a Limited Liability Company. LLCs and S-Corps have some common characteristics but are very different in other ways. Here are some things to keep in mind as you consider your options:
LLCs and S-Corps Both Provide Limited Liability
Both LLCs and S-Corps offer their owners limited liability protection. This is one of the main reasons to incorporate or form an LLC. If you run your business as a sole proprietor, then business creditors can reach any of your assets, even if those assets have absolutely nothing to do with the business. But corporations and LLCs have their own separate existence. They are responsible for the business’s debts, liabilities, and obligations. The liability of the corporation’s shareholders and the LLC’s members is limited to their investment.
LLCs and S-Corps Both Offer Pass-through Taxation
When it comes to federal income taxation, S-Corps and LLCs both offer their owners pass-through taxation. This means that business income and losses are not taxed at the corporate or company level, but “pass through” to the owners and are reported on the individual’s tax returns. This avoids the “double taxation” imposed on C-Corporation dividends that are taxed at both the corporate and shareholder levels. Important, however, is that even though LLCs and S-Corps are pass-through tax entities, they are governed by very different federal income tax rules.
Advantages of LLCs Over S-Corps
Many people prefer the LLC over the corporation because there is more flexibility in how it is managed. Corporation laws (which apply equally to S-Corps and C-Corps) contain more provisions regarding managing the company than LLC laws. For example, corporations must hold an annual shareholders’ meeting, directors’ meetings are required, proper notice must be given and minutes taken, etc. LLC statutes do not have similar requirements.
Furthermore, LLCs can be managed by the members or by managers. Corporations are managed by a board of directors. Shareholders do not manage the business and affairs of corporations. Another advantage of the LLC is that there is greater flexibility in splitting up financial interests. Owners of LLCs can allocate profits and losses disproportionately among owners (for example, if multiple owners have different roles in the business). An S-Corp’s profits and losses must be allocated strictly based upon ownership percentage.
For business owners who own 100% of their business, LLCs also offer the advantage of being able to include your business income and loss on your Form 1040 individual federal income tax return. LLCs with more than one owner are taxed as partnerships and a separate partnership return has to be filed with the IRS (although it is only an information return as the LLC does not pay taxes).
A major advantage of the LLC over the S-Corp is that in order to make the election to be an S-Corp, the corporation:
- •Can have only certain types of shareholders (e.g., individuals, certain estates and trusts, certain tax-exempt organizations)
- •Cannot have more than 100 shareholders
- •Must be a U.S. corporation
- •Can have only one class of stock (but differences in voting rights are permitted)
The IRS restrictions are ongoing. At any time, violating these rules will jeopardize your pass-through taxation. An LLC can achieve pass-through taxation status without any of those restrictions.
LLCs also offer more income tax choices in how you are taxed. By default, LLCs enjoy pass-through taxation under IRS rules. However, by making an IRS election, you could have your LLC taxed as a C-Corp or an S-Corp. A strong caveat here is that if an LLC elects S-Corp taxation, it still has to satisfy all the S-Corp tax rules, and states differ in how they treat the IRS election.
Advantages of S-Corps Over LLCs
S-Corps have some advantages over LLCs. It can be easier to obtain outside funding as some investors and banks prefer to invest in corporations rather than LLCs. Being a corporation is also still considered more of a status symbol. And because corporations have been around so much longer than LLCs, they are more familiar to the lawyers and other professionals who will be providing advice.
S-Corps also offer the ability to receive both salary and dividends, which could lower the overall tax bill (although it should be noted that the salary must be “reasonable” according to the IRS, and the IRS watches this closely). LLC owners, in contrast, pay self-employment taxes, which can result in a higher overall tax liability.
Another advantage of an S-Corp is ease of conversion to a C-Corp. To convert from S-Corp to C-Corp status simply requires the filing of a form with the IRS. Since the state corporation laws do not distinguish between S-Corps and C-Corps, there is no filing necessary with the state’s business entity filing office. On the other hand, LLCs and corporations are totally different entities. To go from an LLC to a C-Corporation, you will have to either merge the LLC into a corporation, enter into a statutory conversion or dissolve the LLC and incorporate. This can be important if you anticipate raising capital by selling shares of stock or by going public. Venture capitalists prefer investing in C-Corps. It is also important if you want to issue preferred stock or have a non-U.S. resident as a shareholder, or otherwise want to do something that will make the corporation ineligible for S-Corp status under the IRS rules.
Both the LLC and S-Corp have their advantages and disadvantages. You may prefer an S-Corp if you:
- •Want to have earnings distributed proportionately to capital contributions
- •Want to earn a salary instead of self-employment income
- •Want ease of obtaining investment capital
- •Want pass-through taxation
- •Want to be a C-Corp later
An LLC might be your choice if you:
- •Want maximum flexibility in running your company
- •Want to allocate profits and losses based upon criteria other than ownership percentage
- •Prefer to avoid the state-mandated meeting requirements imposed on corporations
- •Don’t foresee raising capital by selling ownership stakes to many investors or by going public
- •Feel pass-through taxation is important
Between an LLC and an S-Corp, there is no single choice that is always better for every business owner. The best option depends upon each individual owner’s unique circumstances.
Epps & Coulson, LLP has attorneys well-versed in business and corporate law, including business formation and choice of entity. If you have any questions or need to engage legal counsel, please contact Dawn at firstname.lastname@example.org, Gabe at email@example.com, or Adam at firstname.lastname@example.org.
Information contained in this Memo is intended for informational and educational purposes only and does not constitute legal advice or opinion, nor is it a substitute for the professional judgment of an attorney. It is likely considered advertising. Epps & Coulson, LLP encourages you to call to discuss these matters as they apply to you or your business.
EPPS & COULSON, LLP
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