Assessing which corporate structure to select for your business, both from a legal and operational perspective, is a key factor in setting up your company for success.
Each of the distinct options have advantages and disadvantages in relation to taxes, exposure to liability, and various day-to-day practical elements. The goal of this article is to help you understand the similarities and differences between a limited liability company (LLC) and an S corporation so that you can choose the best one for your business.
As with any decision made regarding your business, it is recommended that you exercise caution and plan carefully when assessing which path to pursue in regards to business structure. Business owners may want to seek counsel from other experienced professionals when weighing the pros and cons of business entities.
Background History of S Corporation and LLC
Let’s take a brief look at the history of these types of corporate entities.
Subchapter S of the tax code was created by Congress in 1958 and eliminated an unfavorable double tax that applied to normal corporations. This encouraged the creation of small businesses and family-owned businesses across the nation, and spurred new growth in entrepreneurial ventures.
The history of the LLC began in 1977 when Wyoming first passed legislation allowing a new type of company called a limited liability company (LLC).
According to DelawareInc.com, this new entity designation didn’t get much attention again until 1993, when, “after subsequent IRS approvals, the Delaware LLC Act became the gold standard among LLC laws. The creation of the LLC allowed for a hybrid entity in which both pass-through tax treatment and limited liability could co-exist, legally, for the first time.”
Similarities Between LLC and S Corporation Structures
It is important to be aware that these entities share commonalities that make each appealing and viable for business owners, including:
- Pass-through taxation. While both entities are generally designated as pass-through tax entities, an LLC will only file a business tax return if the LLC has more than one owner. On the other hand, it is mandatory that an S corporation files a business tax return. The benefit of pass-through taxation is that no income taxes are paid at the business level. Rather, as the terminology suggests, profits or losses related to the business are “passed through” to owners’ personal tax returns and paid at the individual level.
- Separate entities.By creating a filing with the state, both are separate legal entities.
- Limited liability protection. In most cases, owners of either an LLC or S corporation are not personally responsible for business debts and liabilities.
- Ongoing state reporting. Both entities are subject to state-mandated requirements, such as filing annual reports and any fees associated with the filing.
Breaking Down an S Corporation
According to the IRS, “S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. To qualify for S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders
-May be individuals, certain trusts, and estates and
-May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).”
The main benefits cited for the creation of an S corporation are the inherent protection from personal liability, the allowance for pass-through taxation, and an easier conversion to a C corporation designation. Another advantage is that an S corporation owner can receive both a salary and dividend payments from the company, which can result in a lower tax bill.
A drawback to this business structure is that there are more limits on issuing shares and not all companies are eligible for S corporation designation. Furthermore, an S corporation is required to follow formalities such as adopting bylaws, holding annual director and shareholder meetings, and keeping meeting minutes.
Breaking Down an LLC
According to the IRS.gov “A Limited Liability Company (LLC) is a business structure allowed by state statute. Each state may use different regulations, and you should check with your state if you are interested in starting a Limited Liability Company. In addition:
- Owners of an LLC are called members.
- Most states do not restrict ownership, and so members may include individuals, corporations, other LLCs and foreign entities.
- There is no maximum number of members.
- Most states also permit “single-member” LLCs, those having only one owner.”
The flexibility of an LLC is one of the main draws to such a business structure. For example, the advantages include less paperwork and record-keeping than a corporation, protection from personal liability, and the straightforward division of profits among members.
However, there are disadvantages to an LLC that may come into play if your company ever plans on asking for investor money or raising venture capital funds. The income of LLC members is also subject to self-employment taxes, which may be partially avoided with a S corporation.
Other Considerations
In summary, it is important to know that there are other differences that may impact an owner’s business structure decision including transferability of ownership, rules around existence and dissolution, and additional tax regulations.
Knowing if such rules apply to your business situation is imperative, so it is wise to consider contacting your tax advisor or account for a more comprehensive understanding of which structure would best suit your business needs.