Should You Be an LLC or S Corp?

May 22, 2015

Practice Area: Business & Corporate Law

The answer is it depends, as a business owner, on what your goals and objectives are.

Both LLCs and S corporations are tax efficient. LLCs and S corporations are both pass-through entities; meaning, generally speaking, the entity itself is not subject to taxation. Rather, the profits and losses flow through to the owners, who either pay taxes on the profits or get to use the losses to offset income.

Both LLCs and S corporations protect the owners and management against personal liability. If properly formed (LLC) or incorporated (S corporation), structured and operated, the owners and management of either an LLC or S corporation will be protected against personal liability for the debts and obligations of the company.

LLCs provide for a more a flexible capital and ownership structure, both for raising money and implementing employee incentive plans. LLCs offer significant flexibility in dealing with ownership and financial matters, including the fact that (1) a variety of classes of equity interest can be issued, which are similar in nature to preferred stock and common stock in a corporation, (2) individuals and different types of entities alike can be as investors/owners and (3) the profits and losses and cash can be specially allocated and distribute among the owners—in other words, not strictly in accordance with ownership interest. This is significant for a number of reasons, including that investors typically do not invest in their capacity and they want a priority return on their money (meaning, the right to be paid ahead of the company’s owners).

By comparison, an S corporation does not offer comparable flexibility in dealing with ownership and financial matters. These limitations are rooted in the fact in an S corporation (1) only one class of stock can be issued, which can include voting and non-voting common stock, (2) basically, only individuals and certain types of trusts can be investors/owners and (3) profits and losses and cash must be allocated and distributed in accordance with ownership interest. In that regard, in an S corporation, investors are not able to receive a priority return of their capital. And, owners who want to reward employees with an actual ownership interest (often without employees paying anything for the shares of stock) in the company are not able to distribute monies out of the company to themselves without proportionately distributing monies to the employee-shareholders.

S corporations allow owners to distinguish between salary and distributions. An owner of an S corporation can be an employee of the company and therefore be paid a salary. An owner will pay self-employment taxes and FICA on these wages, but not on dividend distributions received from the company. In other words, generally speaking, an S corporation owner can draw a bright line and differentiate between compensation and a distributive share of the company’s income. By comparison, an LLC owner typically cannot draw the same bright line distinction. An LLC owner cannot be an employee of the company and therefore cannot receive a salary. Rather, an owner will often receive “guaranteed payments” (the functional equivalent of a salary). And, if the LLC is engaged in a trade or business, and assuming an owner is actively involved in the LLC, both the guaranteed payments and any other monies distributed out of the LLC to the owner will be each subject to self-employment taxes and FICA.

LLCs suffer the sting of “hot assets” in a sale of the company transaction. For all of its tax efficiency, when an owner sells (in a sale of the company transaction) its ownership interest, the owner must recognize ordinary income (and not capital gains) tax to the extent of the owner’s share of the company’s accounts receivable, inventory and certain other items. There is no comparable limitation or complication for the owner of an S corporation in such sale scenario.

Overall, LLCs and S corporations have similar features to, and certain advantages over, one another. Strategic business planning, as well as consultation with your professional advisors, on the front of end of forming a business will help decipher which entity choice may be more advantageous for your particular business venture.

Please fill following information to download presentation