Choosing the right business structure makes a big difference for your business. Most of today’s small business and franchise owners opt for one of two structures, the limited liability company (LLC) or the S corporation (S corp.). While these business structures offer many of the same benefits, there are distinct advantages and disadvantages to each.
Common Benefits. Two key benefits offered by LLCs and S corps. are limited liability and “pass-through” taxation. Limited liability means that owners generally are not personally liable for the debts and liabilities of the business. “Pass-through” taxation allows these business entities to avoid double taxation—neither LLCs nor S corps. pay corporate-level taxes. Instead, all profits and losses are passed through to the business owners and applicable taxes are paid on their individual returns.
Member & Stockholder Eligibility. LLCs are more flexible when it comes to owner eligibility. Almost any individual or entity may be a member of an LLC. There is no limitation on the number of members or how the ownership interests and specific benefits may be distributed. S corps., on the other hand, are limited to a maximum of 100 individual shareholders who cannot be nonresident aliens, corporations, partnerships, LLCs, or non-qualifying trusts. S corps. are also limited to one class of stock and must distribute dividends, benefits and detriments related to ownership in proportion to each shareholder’s ownership interest.
Observing Corporate Formalities. LLCs are also attractive because of their relative simplicity and flexibility. LLCs require fewer forms and documentation at the outset of formation and throughout the life of the business or franchise. They are not required to observe corporate formalities and may be run either by the members or a group of selected managers, who need not be owners of the company. While corporate formalities generally are not required, LLCs still must be careful to keep business operations separate from the members’ personal affairs to prevent the piercing of the company’s limited liability veil.
S corps. are far more rigid. They are managed by a board of directors and must observe corporate formalities such as annual director and shareholder meetings, keeping meeting minutes, adopting bylaws and issuing stock. S corps. are also limited in their investments and cannot have more than 25% passive income (such as income from real estate investments). S corps. must meet all of the entity requirements or risk being converted to a C corporation, with highly adverse tax consequences.
While all of the extra formalities and paperwork required by S corps. may sound like a pain, they are often beneficial in the end. The corporate formalities and careful records provide concrete proof of decision making processes and demonstrate that the board acted in the best interest of the company, proving very helpful when tax, liability or internal governance issues arise. S corps. may also seem more legitimate to investors, who generally view the corporate structure as more stable than the LLC.
Tax Implications. S corps. are attractive for highly profitable business ventures because they reduce employment taxes on your profits. An LLC must pay employment tax on its entire net income, but S corps. only pay employment taxes on wages paid. S corps. must pay employees reasonable salaries (based on the market rate) but additional profits may be distributed as dividends, which are typically taxed at a lower rate. Plus, S corps. can write off certain employee/shareholder benefits for more savings.
On the other hand, distributions of an LLC’s appreciated property are generally tax free. In S corps., those distributions are taxed on the shareholders’ individual tax returns based on the fair market value of the assets. LLCs may also provide member-level tax adjustments for LLC liabilities such as real estate that is subject to debt and may allocate tax benefits related to depreciation and losses without regard to members’ proportional ownership interests. S corps. may be subject to additional state taxes.
Greater Limited Liability. While LLCs and S corps. both enjoy limited liability, an LLC may be preferable when facing judgment creditors. When a creditor obtains a personal judgment against a member of an LLC, the creditor cannot directly seize the assets of the LLC. Instead, the creditor may obtain a “charging order” requiring distributions that would normally be made to the member to be made to the creditor until the judgment is satisfied. This does not give the creditor the right to participate in management of the LLC or vote on any LLC matters.
When a creditor obtains a personal judgment against the shareholder of an S corp., the creditor may acquire title to the stock owned by the shareholder. This does not give the creditor the right to participate in management of the corporation, but the creditor will be able to vote on company matters. If the creditor only obtains a small number of shares, this does not make much of an impact, but it may be problematic if the creditor obtains a large enough interest to make a real impact during shareholder votes.
Duration. LLCs have limited durations, and when a member dies or undergoes bankruptcy, the LLC must dissolve. S corps. exist in perpetuity and have clearer lines between the business entity and its shareholders. So, if a shareholder dies, sells his or her shares, or leaves the corporation, the S corp. can continue with business as usual.
Combining the Benefits. Business owners and franchisees should keep in mind that LLCs can request S corp. tax status. This allows your business or franchise to remain an LLC for legal purposes but gain the tax benefits of an S corp. To gain S corp. status, an LLC must comply with the S corp. ownership rules but need not follow corporate formalities. So, an LLC with S corp. tax status still has more operational and ownership flexibility than a traditional S corp.
To receive S corp. status, you must file a special election with the IRS using Form 2553. You have to file within the first two months and fifteen days of the year. If you file later, your election will not apply until the next year.
Which to Choose? LLCs, S corps., and LLCs with S corp. tax status are all popular choices for new businesses. Which choice is right for your business or franchise depends on your specific needs. If you’re having trouble deciding between an LLC and S corp., contact us at (312) 216-2720 or firstname.lastname@example.org to consult with one of our experienced attorneys about the pros and cons of each today.