LLCs and S corps both provide limited liability
Both LLCs and S corporations offer their owners limited liability protection. This is one of the main reasons to incorporate or form an LLC to own a business rather than owning it yourself. If you run your business as a sole proprietor, then business creditors can reach any of your assets, even if those assets have absolutely nothing to do with the business. But corporations and LLCs have their own separate existence. They are responsible for the business’s debts, liabilities and obligations. The liability of the corporation’s shareholders and the LLC’s members is limited to their investment.
LLCs and S corps both offer pass-through taxation
When it comes to federal income taxation, S Corps and LLCs both offer their owners pass-through taxation. This means that business income and losses are not taxed at the company-level, but “pass-through” to the owners and are reported on the individual’s tax returns. This avoids the “double taxation” imposed on C Corporation dividends that are taxed at two levels: the corporation and shareholders.
But it is important to keep in mind that even though LLCs and S corps are pass-through tax entities they are governed by very different federal income tax rules. So they are not identical when it comes to how they are taxed.
Advantages of LLCs over S corporations
One of the reasons many people prefer the LLC over the corporation is that there is more flexibility in how it is managed. Corporation laws (which, as noted apply equally to S corps and C corps) contain more provisions regarding managing the company than LLC laws. For example, corporations must hold an annual shareholders’ meeting, directors’ meetings are required, proper notice must be given and minutes taken, etc. LLC statutes do not have similar requirements.
In addition, LLCs can be managed by the members or by managers. Corporations are managed by a board of directors. Shareholders do not manage the business and affairs of corporations.
Another advantage of the LLC is that there is greater flexibility in splitting up financial interests. Owners of LLCs can allocate profits and losses disproportionately among owners; an S corporation’s profits and losses must be allocated strictly based upon ownership percentage. If multiple LLC owners have different roles in the business, this could be especially beneficial.
For business owners who own 100% of their business, LLCs also offer the advantage of being able to include your business income and loss on your Form 1040 individual federal income tax return. This option disappears if the LLC has more than one owner. LLCs with more than one owner are taxed as partnerships and a separate partnership return has to be filed with the IRS. (Although it is only an information return as the LLC does not pay taxes).
A major advantage of the LLC over the S corporation is that in order to make the election to be an S corporation, the corporation:
- Can have only certain types of shareholders (e.g., individuals, certain estates and trusts, certain tax-exempt organizations)
- Cannot have more than 100 shareholders
- Must be a U.S. corporation
- Can have only one class of stock (but differences in voting rights are permitted)
The IRS restrictions never end. At any time, violating these rules will jeopardize your pass-through taxation.
An LLC can achieve pass-through taxation status without any of those restrictions.
LLCs also offer more income tax choices in how you are taxed. By default, LLCs enjoy pass-through taxation under IRS rules. However, by making an IRS election, you could have your LLC taxed as a C corporation or an S Corporation. A strong caveat here – which you should discuss with your tax advisor – is that if an LLC elects S Corp taxation, it still has to satisfy all the S Corp tax rules and states differ in how they treat the IRS election.
Advantages of S corps over LLCs
S corporations have some advantages over LLCs. It can be easier to obtain outside funding as some investors and banks prefer to invest in corporations than LLCs. Being a corporation is also still considered more of a status symbol. And because corporations have been around so much longer than LLCs they are more familiar to the lawyers and other professionals who will be providing advice.
S corporations also offer the ability to receive both salary and dividends, which could lower the overall tax bill. Although it should be noted that the salary must be “reasonable” according to the IRS (and the IRS watches this closely). LLC owners, in contrast, pay self-employment taxes, which can result in a higher overall tax liability.
Another advantage is ease of conversion to a C corporation. To convert from S corp status to C corp status simply requires the filing of a form with the IRS. As noted, the state corporation laws do not distinguish between S corps and C corps so there is no filing necessary with the state’s business entity filing office. However, LLCs and corporations are totally different entities. In order to go from an LLC to a C corporation, you will have to either merge the LLC into a corporation, enter into a statutory conversion or dissolve the LLC and incorporate. This can be important if you anticipate raising capital by selling shares of stock or by going public. Venture capitalists prefer investing in C corporations. It is also important if you want to issue preferred stock or have a non-U.S. resident as a shareholder, or otherwise want to do something that will make the corporation ineligible for S corporation status under the IRS rules.
As you can see, both the LLC and the S corp have their advantages and disadvantages.
You may prefer an S corp if you:
- want to have earnings distributed proportionately to capital contributions
- want to earn a salary instead of self-employment income
- want ease of obtaining investment capital
- want pass-through taxation
- want to be a C Corp later
On the other hand, an LLC might be your choice if you:
- want the maximum flexibility in running your company
- want to allocate profits and losses based upon criteria other than ownership percentage
- prefer to avoid the state-mandated meeting requirements imposed on corporations
- don’t foresee raising capital by selling ownership stakes to many investors or by going public
- feel pass-through taxation is important
Between an LLC and an S corporation, there is no single choice that is always better for every business owner. The best option depends upon each individual owner’s current needs and future plans. Working with a business professional is the best way to determine which is best for you: LLC or S Corp.