This article is for general informational purposes only and does not, and is not intended to, constitute legal or financial advice. Readers should seek the advice of an attorney or accountant before acting on specific matters.
Introduction
Choosing the right legal structure is an important decision to make for a small business that can have a wide range of impacts, such as taxation, personal liability, and administrative requirements. Two of the most popular choices among entrepreneurs are Limited Liability Companies (LLCs) and S Corporations (S Corps). Both entities offer advantages and disadvantages that depend on the specific needs and circumstances of your business.
This article discusses LLCs and S Corps across five key areas: the formation process, ownership restrictions, management structure, tax implications, and personal liability protection. Our aim is to provide you with the information necessary to make an informed decision regarding which entity type best suits your small business.
Formation Process
The formation process for both LLCs and S Corps involves several similar steps, including choosing a business name, appointing a registered agent, and filing necessary paperwork with the state. However, there are some key differences.
To form an LLC, you must file Articles of Organization with your state’s Secretary of State office and create an Operating Agreement that outlines the ownership and operating procedures of the LLC.1 The cost to form an LLC varies by state but generally ranges from $50 to $500.
In contrast, forming an S Corp is slightly more complex. It begins as a regular corporation (C Corp) by filing Articles of Incorporation. Afterward, all shareholders must sign and file Form 2553, which is the IRS form to elect S Corporation status.2 The additional step of filing Form 2553 makes the formation process for S Corps more time-consuming compared to LLCs.
While both entities require certain formalities for establishment, setting up an LLC tends to be simpler and less expensive than forming an S Corp.
Ownership Restrictions
Ownership restrictions are another area where LLCs and S Corps differ significantly. An LLC offers more flexibility in terms of ownership within the scope of the law. LLCs do not have restrictions on the number or type of members they can have. Members of an LLC can include individuals, corporations, other LLCs, or foreign entities.3
On the other hand, S Corps have more stringent ownership requirements. They can have no more than 100 shareholders, all of whom must be U.S. citizens or residents.4 Moreover—according to U.S. tax regulations—S Corps cannot be owned by C Corporations, other S Corporations, LLCs, partnerships, or certain trusts.
This distinction makes LLCs a more flexible option for business owners who anticipate the need to attract investors from various sources or who intend to include corporate entities as owners.
Management Structure
The management structure of LLCs and S Corps also differs. LLCs have a more flexible management structure that allows members to directly manage the company or appoint managers to handle day-to-day operations.5 This flexibility can be beneficial for small business owners who prefer a less formal structure.
In contrast, an S Corp follows a more rigid, traditional corporate structure with directors and officers. Directors make major business decisions, while officers handle daily business affairs.6 Although this may appear more structured, it can provide clarity in roles and responsibilities, which might be advantageous for businesses with multiple owners.
Therefore, if you prefer a management style that is flexible and involves fewer formalities, an LLC could be the appropriate choice. However, if your business would benefit from a more structured approach and clearly defined roles, consider forming an S Corp.
Tax Implications
Taxation is a crucial factor to consider when choosing between an LLC and an S Corp. By default, LLCs are treated as pass-through entities for federal tax purposes, meaning the company itself does not pay federal income taxes. Instead, profits and losses are passed through to the owners’ personal tax returns.7 The owner needs to file Form 1040, Schedule C, Profit or Loss from Business to report the profits or losses from the LLC on their personal tax return.
S Corps also have pass-through taxation and can provide potential savings on self-employment or Social Security/Medicare taxes. In an S Corp, owners who work in the business are considered employees and must be paid a “reasonable” salary prior to the distribution of any dividends. Only this salary is subject to employment tax, potentially leading to significant savings.8
Owners of an S Corporation (S Corp) need to file Form 1120S, U.S. Income Tax Return for an S Corporation. This form is specifically for S Corps and is used to report the income, deductions, gains, and losses of the S Corp. Additionally, S Corp owners may also need to file Form 1040, Schedule E, Supplemental Income and Loss, to report any income or losses from their ownership of the S Corp on their personal tax returns.
In essence, while both LLCs and S Corps provide pass-through taxation benefits, S Corps may offer additional advantages for individuals who are comfortable navigating their more intricate requirements.
Personal Liability Protection
Both LLCs and S Corps offer personal liability protection, which is a significant advantage over sole proprietorships and partnerships. This means that owners are typically not personally responsible for business debts and liabilities.
In an LLC, the personal assets of its members are protected from creditors who wish to collect from the business.9 Similarly, in an S Corp, shareholders have limited liability for debts or actions of the corporation. However, in certain circumstances, the courts can “pierce the corporate veil” and hold individual owners personally liable for the business’s obligations. This typically occurs when there is commingling of personal and business funds, fraudulent activities, or failure to meet legal requirements for maintaining separate entities.10
While both entity types provide a layer of personal protection, owners should be aware of the risks and take necessary steps to maintain the separation between personal and business affairs. Additionally, maintaining proper insurance coverage is always recommended to further protect against unforeseen liabilities.
Conclusion
Choosing between an LLC and an S Corp for your small business is a decision that should be based on the specific needs, goals, and circumstances of your venture. Both offer valuable benefits such as personal liability protection. However, they differ in areas such as the formation process, ownership restrictions, management structure, and certain tax implications.
LLCs tend to provide more flexibility in terms of ownership and management structure while also offering a simpler formation process. On the other hand, S Corps can potentially offer tax savings on self-employment taxes and may be beneficial for businesses that prefer a traditional corporate structure with clearly defined roles.
It’s important to remember that there is no one-size-fits-all answer when it comes to choosing a business entity type. Consulting with legal or financial advisors can provide personalized guidance tailored to your unique situation. Ultimately, understanding these key differences will empower you to make the best choice for your small business.