One of the most confusing decisions you can face as a new business owner is determining the legal structure of your company. The two most common options are S Corporation and LLC, the major differences of which are highlighted below.
S Corporation, or S Corp, is a tax designation from Subchapter S of the first chapter of the Internal Revenue Code. Every S Corp begins as a C Corporation, which then files an S Corp election with the Internal Revenue Service (IRS). A major benefit of S Corporations is pass-through taxation. In other words, taxes on profits pass through the business and go straight to the owners and shareholders, who then pay individual income taxes on the profits they receive. This not only avoids double taxation, but it also taxes profits at the personal tax rate, rather than the significantly higher corporate tax rate. In a C Corporation, both the business and its owners are taxed on profits. In order to have S Corp status, a business must:
– Elect S Corp status within the first two months of the tax year and continue to make the S Corp designation every year thereafter.
– Be a domestic firm.
– Have no more than 100 shareholders.
– Issue only one class of stock.
– Follow stringent operational rules, including filing an annual report, adopting and continuously updating bylaws, maintaining proper stock transfer records, and sending notice of and holding yearly stockholder meetings.
The penalty for not following all regulations is that a company’s S Corp status will be found invalid. In such a case, all tax benefits and liability protection are lost. Should there be any legal judgments against the company, they would therefore be levied against the business owners’ personal assets.
Limited liability companies (LLCs) offer many of the same tax advantages and liability protection as S Corps. However, there are significant differences between the two types of firms. For instance, unlike S Corp owners, LLC owners must pay self-employment tax, which can be substantial. Furthermore, LLCs have members, rather than shareholders. Membership entails close ties to the company through controlling interest, which is more difficult than shares to transfer to another individual. There are certain benefits to LLC status. When an LLC is formed, an operating agreement is established that clearly delineates the rights, responsibilities, and amounts of profits to which each member is entitled. There is much flexibility in how membership is divided, as opposed to the share-based structure of an S Corp. A main draw for many business owners is that under LLC status, they are not bound by the tight regulations of an S Corp to follow certain operating procedures like annual meetings or bylaw updates.
How to Choose
Companies of some types, such as those in the finance and insurance industries, are prohibited from operating as LLCs. However, as a business owner, you will most likely choose to establish your business as either a corporation or an LLC. The following three questions can help steer you in the right direction:
– Who is going to own the company?
- An LLC is great if you are going to have two or more owners coming in and taking active roles in the company. Do not file as an LLC if you are the only owner because you will not be getting the flexibility or tax benefits anyway.
– Where are you getting your startup or expansion funds?
- If you are seeking a large amount of capital from outside investors, a corporation is preferred. If you unexpectedly raise funds from more than 100 shareholders, you can easily revert to C Corp status.
– What will the business look like if it is successful?
- If you intend to issue multiple classes of stock or use equity crowdfunding, a corporation is preferred to an LLC.
Always remember that choosing your legal structure is not a one-shot deal. You can change your entity type in the future through a fairly simple process. However, consulting an adviser in your decision is always the best route. By starting out on the right foot from the beginning, you will avoid significant tax costs down the road.
Adapted from: Brooks, Chad. “S Corporation vs. LLC: Which is Best for You?.” BusinessNewsDaily. N.p., 17 Apr. 2014. Web. 22 Apr. 2014. <http://www.businessnewsdaily.com/6257-s-corporation-vs-llc-business-entity.html>.