Maybe you’re launching a new business or your company is entering a growth period. Either way, as a small business owner you’ll want to protect your assets in case of bumps along the way. But how can you decide if it’s better for you to structure your business a Limited Liability Company (LLC) or S corporation (S corp)?
Here are some important factors to consider if you are trying to decide how to move beyond sole proprietorship:
LLCs and S corps are both legal entities after you file with a state-level secretary of state. There’s also a pay a one-time filing fee. Both offer limited liability protection, where company owners aren’t typically responsible for their business’s debts and liabilities. Although you can file in any state, Delaware is overwhelmingly the most popular for multiple reasons, including a separate court for businesses. Nevada and Wyoming are also “business friendly.”
S corps and LLCs business owners calculate taxes based on their net profits or losses. Typically S corporations usually pay more in taxes – thanks to payroll taxes and state taxes. However, they can vary according to the state.
Both must file annual reports, pay ongoing fees and are popular because of their pass-through taxation and liability protection. Unlike C corporations which may face double taxation and can expect taxes at the corporate and personal levels, LLCs pass their company income through the tax returns of the company owners. Similarly, S corporations typically avoid double taxation by passing through income, usually by paying out dividends while also protecting owners’ personal assets from corporate liabilities.
S corporations are taxed under the Subchapter S of Chapter 1 of the Internal Revenue Service code. They typically don’t pay any federal income taxes, since profits and losses are passed through its shareholders. Shareholders then must report these earnings, or losses on their individual income tax returns. There isn’t an official LLC tax classification; so LLCs can elect to be taxed as a sole proprietorship, partnership or corporation. Check with the IRS for more details.
LLCs are popular with a lot of start-up businesses because of fewer complications and expenses to set up. Many business owners consider S corps because they may have more ideal self-employment taxes than an LLC. In an S Corp, an owner can treated like an employee and paid a salary. Although the company owner’s salary is still subject to Federal Insurance Contributions Act – commonly known as FICA –taxes, the net profit isn’t subjected to the same Social Security and Medicare taxes.
An LLC is considered the most flexible and tax-efficient business entity. There aren’t restrictions on shareholders or equity classes. However, it can also be more expensive to form. Many states require LLCs to create an operating agreement, similar to corporate by-laws. It helps to structure your financial and working relationships. If there are co-owners, this agreement establishes the percentage of ownership, everyone’s share of profits and losses, responsibilities and exit agreements.
While anyone, including non-U.S. citizens and residents can own or be members of an LLC, that’s not the case for S corporations, which have stricter requirements. An S Corp must be a domestic corporation, where only U.S. citizens, and certain qualifying trusts, are shareholders. You can’t have more than 100 shareholders and may only have one class of stock. S corps can’t have ownership by other S corps, LLCs, partnerships or many trusts or C corporations. LLCs don’t have such restrictions and do have permission to have subsidiaries.
While S corps are required to adopt bylaws, hold annual shareholder meetings, keep meeting minutes and issue stock, LLCs have less stringent guidelines that are recommended but not required. This includes holding annual member meetings, documenting company decisions and procedures as well as issuing member shares. S corps must have a board of directors and officers who elect officers to manage the day-to-day operations of the business.
Some company owners choose to become an S corp if they intend to stay small, not borrow money and only plan on having individual shareholders from the U.S.. Otherwise, some owners who think they may take on debt or equity from investors opt to become an LLC.
While these organizational forms are similar, the differences are nuanced enough to invest time to evaluate your choices. Do so with your accountant or attorney. Deciding what the best fit is for your goals can mean avoiding additional costs down the line as your business changes.