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LLC vs. S-Corp

Posted December 26th, 2012 by bbsadmin & filed under General Business, Start-Ups.

LLCs and S corps have much in common:

Limited liability protection. With both, owners are typically not personally responsible for business debts and liabilities.
Separate entities. Both are separate legal entities created by a state filing.
Pass-through taxation. Both are typically pass-through tax entities, and while S corps must file a business tax return, LLCs only file business tax returns if the LLC has more than one owner. With pass-through taxation, no income taxes are paid at the business level. Business profit or loss is passed-through to owners’ personal tax returns. Any necessary tax is reported and paid at the individual level.
Ongoing state requirements. Both are subject to state-mandated formalities, such as filing annual reports and paying the necessary fees
One of the features that distinguishes the LLC from an S-Corp is its operational ease. There are far fewer forms required for registering and there are fewer start-up costs. Filing taxes is a once-a-year affair on April 15: a single-member LLC files a 1040 and Schedule C like a sole proprietor; partners in an LLC file a 1065 partnership tax return like owners in a traditional partnership. Moreover, LLCs are not required to have formal meetings and keep minutes.

There are also fewer restrictions on profit-sharing within an LLC as members distribute profits as they see fit. Members might contribute different proportions of capital and sweat-equity. Consequently, it’s up to them to decide who has earned what percentage of the profits or losses.

But LLCs are not the perfect entity for all businesses. First, an LLC has a limited life, but in Utah that is 99 years which is far longer than most of us will live and you can always convert to a corporation. Also when a member dies or undergoes bankruptcy the LLC may be dissolved, but only if there is only one member and the operating agreement says it will dissolve. Typically, you would determine in advance the length of the LLC’s duration when you file it with your state. If your plans include taking your company public or issuing shares to your employees, essentially prolonging its life, then you would need to convert to a corporate business structure.

Second, the owner of an LLC is considered to be self-employed and must pay the 15.3% self-employment tax contributions towards Medicare and social security. As such, the entire net income of the LLC is subject to this tax. It costs money to have some operational ease! This is not a big issue if all the funds in the company are essentially for the benefit of one owner – they an S-corp is treated similarly.

One of the best features of the S-Corp is the potential short term tax savings for you and your business. Recall that members of an LLC are subject to employment tax on the entire net income of the business. Conversely, only the wages of the S-Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a ‘distribution’ which is taxed at a lower rate if at all! This is only a benefit to the extent the company makes a lot of money and does not distribute it to the owners or shareholders.

As I mentioned before, in a corporation, the shareholder must receive reasonable compensation. If you try to cheat the system by paying yourself a lower salary and higher distributions you might get a tax advantage for the year, but the IRS takes notice of such red flags. If they reclassify your distributions as wages you’ll be back to paying the higher employment tax and you will have the IRS’s attention.

Keep in mind that some benefits that shareholder/employees receive can be written off as business expenses. Nevertheless, if such an employee owns 2% or more shares, the benefits like health and life insurance are deemed taxable income.

An S-Corp also allows the business to have an independent life separate from the shareholders. If a shareholder dies, leaves the company, or sells his or her shares the S-Corp can continue doing business relatively undisturbed. By maintaining the business as a distinct corporate entity, clearer lines are defined between the shareholders and the business that improve the protection of the shareholders

The tax savings and solidity of the S-Corp also come with a price. As a separate structure, S-Corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers and records maintenance.

If your company is considering raising venture capital down the road, VC firms will most likely choose the C Corporation as the type of legal entity for their investments. This doesn’t necessarily mean your business needs to start as a C Corp, but be advised: If you are considering raising venture capital and start out with an LLC or an S Corp, you will need to convert the business to a C Corp (if your state allows conversions) at some point. This conversion will require additional filings and fees within your state. If you choose this route, you may want to consider the S Corp as your option, since converting an S Corp to a C Corp can be done in a day with a single tax form (you’re basically unchecking the box for S Corp tax election on an IRS form).

Summary Differences

1. Ownership. The IRS restricts S corporation ownership, but not that of limited liability companies. IRS restrictions include the following:

LLCs can have an unlimited number of members; S corps can have no more than 100 shareholders (owners).
Non-U.S. citizens/residents can be members of LLCs; S corps may not have non-U.S. citizens/residents as shareholders.
S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships or many trusts. This is not the case for LLCs.
LLCs are allowed to have subsidiaries without restriction.
2. Ongoing formalities. S corporations face more extensive internal formalities. LLCs are recommended, but not required, to follow internal formalities.

Required formalities for S corporations include: Adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings, and keeping meeting minutes with corporate records.
Recommended but not required formalities for LLCs include: Adopting an operating agreement, issuing membership shares, holding and documenting annual member meetings (and manager meetings, if the LLC is manager-managed), and documenting all major company decisions.
3. Differences in management.

Owners of an LLC can choose to have members (owners) or managers manage the LLC. When members manage an LLC, the LLC is much like a partnership. If run by managers, the LLC more closely resembles a corporation; members will not be involved in the daily business decisions.
S corps have directors and officers. The board of directors oversees corporate affairs and handles major decisions but not daily operations. Instead, directors elect officers who manage daily business affairs.
4. Other differences. Other differences between S corps and LLCs include:

Existence. An S corporation’s existence is perpetual, but some states require LLCs to list a dissolution date in the formation documents. Certain events, such as death or withdrawal of a member, can cause the LLC to dissolve.
Transferability of ownership. S corporation stock is freely transferable, as long as IRS ownership restrictions are met. LLC membership interest (ownership) typically is not freely transferable—approval from other members is often required.
Self-employment taxes. S corporations may have preferable self-employment taxes compared to the LLC because the owner can be treated as an employee and paid a reasonable salary. FICA taxes are withheld and paid on that amount. Corporate earnings after payment of the salary may be able to be treated as unearned income that is not subject to self-employment taxes. For more information and whether this might apply to your particular situation, please contact your accountant or tax adviser.