Entrepreneurship has been called the new American dream. Being self-employed starts with an idea that develops into a business plan, but not without careful financial and legal considerations. Among the decisions that new business owners grapple with is whether to form a limited liability company taxed as a partnership (LLC) or a corporation making an S election (S corp).* There are similarities and differences between LLCs and S corps that business owners should understand before choosing between the two.
- Both entities are created by filing the necessary paperwork with the state. Unlike a sole proprietorship or a general partnership, LLCs and corporations are not recognized under state law until the filing has been made. In addition to state filings required to form the corporation, a special filing on Form 2553 is required for the state-law corporation to elect S status for federal tax purposes.
- Both entities provide owners with limited liability, meaning the owner’s personal assets are protected from any business creditors’ claims.
- Assuming an LLC does not make an election to be taxed as a corporation, both LLCs and S corps are pass-through tax entities, allowing business profits and losses to flow through and be reported on the owners’ personal tax returns.
- Unlike LLCs, which can have an unlimited number and type of owners, S corps are subject to strict ownership rules. S corps can have no more than 100 shareholders, may not have non-U.S. citizens as shareholders, and cannot be owned by corporations, LLCs, partnerships, or many types of trusts.
- As opposed to LLCs, which have flexibility in structuring the economic arrangement among its owners, S corps cannot issue classes of stock with different economic rights. However, an S corp can issue voting and non-voting classes of stock.
- S corps are subject to mandatory requirements as to how the entity is managed. For example, S corps are often required to adopt bylaws, issue stock, hold regular meetings, and maintain meeting minutes within its corporate records. LLCs, on the other hand, are not subject to these types of requirements.
- Owners of S corps, unlike LLCs, may be able to reduce or eliminate the need to pay self-employment tax. An S corp owner can be treated as an employee and paid a reasonable salary. Employment taxes are withheld from the reasonable salary, while corporate earnings in excess of that salary may be distributed to the owners as unearned income, free of self-employment tax.
- S corp owners must share profits equally based on their percentage of ownership, while LLC owners have wide latitude to split profits and losses in any manner that is agreed upon.
- LLCs are generally cheaper to form and operate.
- S corps generally provide enhanced asset protection, as the structure creates more separation between the owners and the company.
*For the sake of simplicity, this brief overview is based on the assumption that (i) any reference to “LLC” is to an LLC taxed as a partnership, and (ii) any reference to “S corp” is to a corporation taxed as an S corporation. These entities are easily confused, in part because an LLC can make an S election. In that case, you have a state law LLC taxed as an S corporation under federal law. Why would anyone choose to do that? In many cases, it is the business owner’s desire to avoid strict state law corporate compliance coupled with the desire for favorable S corp taxation.
Each business has its own set of circumstance to consider and it is important to obtain competent legal advice when staring your own business. I am here to discuss how to properly structure, form, and protect your business. Please give me a call at (858) 432-3923 to schedule a consultation.
Sign up for the Cheever Law Newsletter