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Difference Between LLC and S Corp

You’ve finally started a business of your own or maybe you have been working as a sole proprietor, even moonlighting on the side, and have decided that from this point, you need to protect your personal assets with those who are involved with your growing business. You might even decide that there could be a tax break in it for you. Whatever the reasons, you’re likely witnessing a choice that many entrepreneurs face: Should your enterprise be structured as a limited liability corporation (LLC) or an S corporation (S corp)? Both limited liability company and S corporation share many similar qualities, they also have many differences. Get acquainted with each before deciding which might be right for you.

Let’s begin with learning what each of them means:

What is an LLC?

The exact definition of LLC varies from state to state slightly but, basically, an LLC is a business entity that is legally separate from its owners or “members.” An LLC can have both one or many members.

Small business owners often choose LLC as their business entity instead of a corporation because LLCs offer flexible environment and in this way, they can manage and usually have fewer recordkeeping and reporting obligations than corporations.

What is an S corporation?

Unlike C corporation or LLC, an S corporation designation refers to the way a business has chosen to be taxed under the Internal Revenue Code (IRS).

Limited Liability Companies and S Corporations both are fast becoming more and more popular as business organizational vehicles for those looking for the benefits of limited liability protection while at the same time seeking the same pass-through taxation benefits of partnerships. They both offer attractive solutions to companies wishing to reap these benefits. While at first glance they may appear quite similar, offering similar benefits and features, they actually differ in many substantial ways.

LLC formation really came unto its own at the end of 1996 when the “check-the-box” taxation regulations were passed and LLCs were allowed to enjoy, among other things, limited liability, flexibility of management, and the option to “check the box” and elect pass-through taxation. In this same time frame, corporation rules were being revised significantly in order to allow certain corporations that met sub-chapter S requirements to enjoy limited liability protection while acquiring the ability to enjoy pass-through taxation in the same manner as a partnership. These changes were enacted by Congress in order to meet the demands and outcry from lobbyists that something be done to alleviate the tax plight faced by small businesses. The act came to be known as the Small Business Protection Act of 1996, and consisted of 17 statutory amendments to corporation taxation law. Among other provisions, these amendments enabled S corporations to have up to 75 shareholders, and also allowed an S corporation to own any percentage of stock in a C corporation, though the reverse is not true–a C corporation or LLC cannot hold stock in an S corporation. S corporations have to follow strict stock classification and ownership rules.

These changes forced many people that were immediately “sold” on the LLC formation for their company to reconsider this new subchapter S formation. However, with careful review and guidance, it is apparent that there are situations where it is more beneficial to a company to retain the LLC status, and conversely, there exist situations where it is advisable to elect subchapter S status.

Differences in ownership and formalities

Ownership – The IRS restricts S corporation ownership, but not that of limited liability companies. IRS restrictions include the following:

  • LLCs can have an unlimited number of members; S corps can have no more than 100 shareholders (owners).
  • Non-U.S. citizens/residents can be members of LLCs; S corps may not have non-U.S. citizens/residents as shareholders.
  • S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships or many trusts. This is not the case for LLCs.
  • LLCs are allowed to have subsidiaries without restriction.

Ongoing formalities – S corporations face more extensive internal formalities. LLCs are recommended, but not required, to follow internal formalities.

  • Required formalities for S corporations include: Adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings, and keeping meeting minutes with corporate records.
  • Recommended formalities for LLCs include: Adopting an operating agreement, issuing membership shares, holding and documenting annual member meetings (and manager meetings, if the LLC is manager-managed), and documenting all major company decisions.

Which is better?

It may not matter in most situations. However, where S corporation rules forbid a certain type of owner, the LLC allows it.

Basis rules

Owners can write-off business losses passed through to them from the business only to the extent of “basis.” The term has different meaning for purposes of LLCs and S corporations.

  • LLCs — basis is the owner’s capital investment in the business and his or her share of the business’ debts. For example, if the business borrows $100,000 to buy property and there is one LLC member, he or she can add this $100,000 to basis.
  • S corporations — basis is the owner’s basis in stock (what he or she paid for the stock) plus basis in debt (what he or she loaned to the corporation). Third-party loans to the corporation do not impact the owner’s basis. Third-party loans to the corporation that the owner guarantees become part of basis only when and to the extent the owner must make good on the guarantee.

Which is better

For businesses involving real estate investments, the LLC provides a greater basis advantage.

Employment taxes

Owners should not only be concerned with income taxes; they should also consider the impact of entity choice on Social Security and Medicare taxes.

  • LLCs — owners are self-employed individuals subject to self-employment tax (which covers both the employer and employee share of FICA for Social Security and Medicare taxes). As a general rule, owners must pay self-employment tax on their share of net earnings from the business. Some tax professionals have argued that there should be limitations on this rule for owners who are “silent partners” and who do not provide any personal services for their business. The IRS has yet to provide any definitive guidance on this point.
  • S corporations — owners who work for their business are employees. FICA is imposed only on wages paid to these owners. While there may be a temptation to pay no wages since the owners must report all of their share of net income from the business for income tax purposes, the IRS says you can’t do this. Owners must receive (and pay FICA on) reasonable compensation for work performed. Making sure that S corporation owners do not skirt this rule has become a key audit target of the IRS.

Which is better

For owners who work for their business, there may be less employment tax cost with an S corporation.

State tax rules

Each state has its own rules for LLCs and S corporations. These rules impact the cost of forming the entity, the annual cost of registration to do business within the state (which can be an issue for businesses operating in more than one state), and the income tax treatment of the entity and its owners. To find the rules for your state, go to the *Federation of Tax Administrators and click on your state.

Raising capital

Theoretically, if you want to borrow money for a start-up or take in investors, there should be no difference between these entity choices. However, as a practical matter, the S corporation may offer an edge—this type of entity has been around longer so potential lenders/investors are more familiar with and prefer to deal with S corporations.

What do you foresee for your business? If it includes going public or taking on a large number of new owners, the S corporation may be the better choice for you now. While the S corporation election will have to be terminated in order to become a publicly-held company, this is easy to do and using the S corporation now avoids the need to form a new entity.

Conclusion

Now which entity choice is better for you? Look over the various points and see which type of entity is right for you. Because of the importance of your choice of entity (you can update your status at a later date but there may be a tax cost for doing so), talk with a legal or tax advisor.