Presumably you’re thinking about whether to organize your small business as a subchapter S corporation or a limited liability company because both forms of organization can protect your personal assets without the double taxation that subchapter C corporations face.
Which one is better? The truth is, it depends on what your business does, what your management preferences are and where you want to go in the future. To complicate the issue, an LLC can also choose to be taxed as an S Corp. To find the answer that is right for your business, look at six questions.
Are You Planning to Do This Yourself?
And can we talk you out of that? This is a decision with long lasting consequences, so you should get some professional advice. If you absolutely insist on potentially disastrous legal DIY, LLCs are cheaper and simpler to form. They are easier to operate with few formal requirements and can be quite flexible. It may be the best form of organization for you, but without legal or tax accounting advice, this would only be a happy accident.
Who Owns and Controls the Business?
S Corps may not have more than 100 shareholders, all of whom must be human beings, not other corporations. All the shareholders must also be U.S. citizens or residents. Profits and losses must be allocated according to share holdings. Directors and officers manage the business, as they do in a C corporation.
LLCs are not so limited. Distributions may take into account “sweat equity,”so that a member who put up only 10 percent of the capital but does 90 percent of the work might share equally with larger contributors. LLCs may be managed equally by all members, as often happens with very small LLCs, (the member managed model) or the members may hire a manager, who will report to them (the manager managed model).
Your choice will depend on prior understandings about distributions and collective preference about management style.
What Will Your Business Do?
Generally, under state law, banks and insurance companies may not organize as LLCs. Assuming that your business is neither of those, the essential question is whether your enterprise actively transacts business or simply holds an asset, such as real estate, that produces passive income. In the latter case, an LLC is the better choice because S Corps are very limited in the amount of passive income they may have.
Who Pays the Employment Tax?
Both S Corps and LLCs are pass-through entities for income and state franchise tax purposes, but they do pay Social Security and Medicare taxes for employees. All the owners of an LLC are considered to be self-employed and so must pay a “self-employment tax” of 15.3 percent on the entire net income of the business.
In an S Corp, on the other hand, only the salaries paid to employees are subject to employment tax. Since distributions are not, more than one entrepreneur/employee has tried to finesse the situation by taking only a very small salary, augmented with generous distributions. It won’t work. The IRS evaluates whether salaries are reasonable by industry standards, and where they are not, will re-characterize distributions and assess taxes.
So, from the employment tax perspective, the choice is a matter of weighing the pain of self-employment tax on all revenues against the pain of the same tax on a reasonable executive salary.
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What Are Your Plans for the Future?
Because S Corps are perceived as having an existence independent of the shareholders, many investors are more comfortable with S Corps than LLCs. If your business is about to seek outside capital, you may end up converting it into an S Corp, with all the attendant formalities of holding meetings, electing officers and producing financial statements. If that is your plan at the outset, you might skip a step by starting as an S Corp.
One of the major disadvantages of an LLC is that it is considered to be a resident, and thus subject to the jurisdiction of the courts, in every state in which a member resides. Maintaining that much legal coverage can be expensive. If an S Corp does business in several states, multi-state tax accounting can also become burdensome. So which form of organization is better for multi-state operation? The answer may be neither. A plain, ordinary subchapter C corporate structure may work better.
An S Corp continues to exist if a shareholder dies or sells his or her shares. LLCs, on the other hand, generally have a limited life. The details of how and when a member may transfer an interest in the business, what happens when a member dies or when dissolution will occur must be spelled out in the operating agreement. Planning your exit or the future of the business without you should be part of your initial business plan, and organizational structure is an important piece of that.
What About Being Both an LLC and an S Corp?
It’s not a question of either/or. The designation “LLC” is a matter of state law and, by itself, has no federal tax significance. An LLC with one member might be taxed as a sole proprietorship; LLCs with more members can choose to be taxed as corporations or partnerships, although most choose partnership status. There may be good reason, however, to elect to be taxed an S Corp, instead. This sort of layering should be evaluated thoroughly with an attorney and tax adviser.
Should you organize your business as an S Corp? An LLC? Neither or both? Don’t you hate it when your lawyer answers a question with a question? The choice is important for the future of your business, so it has to follow from some careful thinking about what you want its future to look like.