Understand the pros and cons of each option before you finalize your plans.
Forming a corporation is often one of the first major choices that an entrepreneur has to make. Even established business owners may re-evaluate this decision from time to time as the companies grow and change. Unfortunately, there is no magic process that will provide the correct choice. The differences (and similarities) between the two options may be difficult to understand.
Let’s try to simplify things here by defining the two options and then listing the advantages of each. The other type of corporation, known as a C corporation (C corp), is generally for larger companies, so we’ll focus on just limited liability companies (LLCs) and S corporations (S corps) here.
What is an LLC? What is an S Corp?
The LLC structure is designed to provide the limited liability features of a corporation with the tax efficiencies and operational flexibility of a partnership. S-Corporations are considered by law to be a unique entity, separate and apart from those who own it.
LLCs and S corps have a number of things in common:
- Limited liability protection. Business owners can protect their personal assets, and are not typically responsible for business liability and debt.
- Pass-through taxation. Business profit or loss is normally reported on the owners’ personal tax returns. S corps, and LLCs with more than one member, still have to file a tax return.
- State Requirements. Both are separate legal entities created by a state-level filing, and require filing of annual reports.
Here are some advantages of choosing an S corp structure:
- Self-employment taxes. S corp profits are not subject to Social Security or Medicare taxes. Profits from an active LLC are subject to these “self-employment taxes” of 15.3%.
- Business Life. Where LLCs typically have limited life spans, an S corp has a life independent of its shareholders. As an example, if more than 50% of LLC ownership changes in a 12 month period, the LLC terminates. With an S corp, if you sell 51%, the corporation still survives.
Here are some advantages of choosing an LLC structure:
- Flexibility. Under certain circumstances, LLCs may allow disproportionate splitting of profits (and losses) among members.
- Fewer business formalities. S corps must issue stock, hold regular board and shareholder meetings, maintain corporate minutes, etc. Along with the additional tax filing requirements, these formalities may take require extra time and expense vs. an LLC.
- Fewer ownership restrictions. There can be an unlimited number of owners/members, including non-US residents. There are also no restrictions on subsidiaries.
Enhanced stature of LLCs
While S corps used to be perceived as a more “credible” structure, times have changed. Some banks, venture capital firms, and vendors still favor doing business with corporations, but the growth in the volume and credibility of LLCs is quickly negating any difference in perception. Changing your corporate status later isn’t impossible, but it takes a little time, a meeting with your CPA, and some paperwork filed with your state. There may also be tax consequences, so choose wisely.
Which structure is best for my company?
Each business situation is unique, and there is rarely an obvious answer to this question. Most often the decision requires a review of both options to determine the best option based on the owners’ needs, the specific business, and the tax situation. Your best bet is to schedule a meeting with a CPA from Bach, James, Mansour & Company. We will review your specific situation and offer recommendations for how best to incorporate your business.
Neal Bach, CPA