In my previous post I advised small businesses about the upcoming March 15 deadline for S Corp election. I wanted to follow up with a more detailed look at the two most popular business entities for small businesses: the S Corporation and LLC (Limited Liability Company).
These two entities share several key similarities. Perhaps most importantly, both will protect your personal assets from any potential liabilities of the company (whether from an unhappy customer, unpaid supplier, or anyone else who might pursue legal action). With both the S Corporation and LLC, your personal finances, home vehicles and other assets are all safe. In addition, both structures allow a business to borrow money and sell equity in order to raise capital. Both stay in existence until they are dissolved, without need for periodic renewal. And both offer pass-through tax treatment when it comes to federal income tax.
Given these similarities, how do you decide which is the better choice for your particular business? While circumstances vary among individuals and individual businesses, here are some general guidelines to help you understand the differences and their impact.
1. Business Formality
The LLC is ideal for companies that don’t want or need much formality, but still want legal protection. In a corporation (S-Corp or C-Corp), Articles of Incorporation must be filed; bylaws have to be written; officers have to be named; a board of directors elected; and minutes must be filed and resolutions passed whenever you want to make changes to the company. In the LLC, this isn’t the case. LLCs just use an informal “operating agreement.” Depending on your particular type of business and the individuals involved, this could either be a great time and money saver, or the gateway to potential conflict down the road.
2. The S Corporation Restricts Who Can Be a Shareholder
An S Corp cannot have more than 100 shareholders (of course, this limitation is probably not of much consequence to many small businesses). All individual shareholders must be either U.S. Citizens or permanent residents. By contrast, the LLC does not have such restrictions on owners.
3. The S Corporation Has Strict Income Allocation
In an LLC, income and loss can be allocated disproportionately among the owners; in the S Corp, income and loss are assigned to each shareholder strictly based on their pro-rata share of ownership.
So what does this mean? If I own 80 percent of an LLC, my share of the tax burden doesn’t necessarily have to be 80 percent of the taxable income. But if I own 80 percent of an S-Corp and that company makes $100,000 in taxable income, I will be taxed on $80,000 of income.
4. The S Corporation Cannot Increase Pass-Through Losses
In certain circumstances, the IRS allows the loss in an S Corp or LLC to pass through to the individual shareholders. However, the LLC allows you to pass through more loss than in the S Corp, most notably when it comes to real estate. In an LLC used for real estate investments, however, the members are allowed to add the amount of the mortgage to their basis for the purpose of computing a loss. Clearly, that can add up to a significant difference in your tax statement.
5. Venture Funds Typically Do Not Want to Invest in LLCs
If your company is considering raising venture capital down the road, be advised that the C Corporation is a venture capital firm’s clear choice for the type of legal entity for their investment. Converting an LLC into a C Corp entails a complete merger and can be a rather complicated process involving accountants and possibly lawyers. By contrast, converting an S-Corp to a C Corp can be done in a day with a single tax form (you’re basically unchecking the box for S Corp tax election).
Choosing the right business structure for your business is a weighty issue and will ultimately depend on all the unique aspects of your particular business needs, vision and circumstances. But no matter what entity you choose, taking a serious look at your legal structure is important and will help you scale far more smoothly (and avoid any legal and liability pitfalls) in years to come.