A business structure, in terms of the legal entity you choose for your business, significantly impacts a number of important issues in your business life, including exposure to liability, and at what rate and in what manner you and your business are taxed. Your choice of corporate structure can also substantially affect issues such as financing and growing the business, the number of shareholders the business has and the general manner in which the business is operated.
In addition to the basic legal requirements for various types of business entities that are generally codified at the federal level, there are variations between state laws regarding incorporation. Therefore, it is generally considered a good idea to consult with a corporate lawyer or accountant to make an informed decision regarding what type of business entity is best suited for your specific business.
The choices of limited liability companies (LLCs) and S corporations are increasingly popular due to their basic benefits of liability protection and pass-through taxation. LLCs protect the owners' personal assets from losses, company debts or court rulings against the company. LLCs also avoid the double taxation to which C corporations are subject by passing all company income through to the tax returns of the individual owners. An S corporation structure also protects business owners' personal assets from any corporate liability and passes through income, usually in the form of dividends, to avoid double corporate and personal taxation. However, while both options offer these basic benefits in one form or another, there are significant distinctions between them that require careful consideration when establishing a business entity.
Both LLCs and S corporations surged to the forefront around the time of the Small Business Protection Act of 1996 that contained a number of changes to basic corporate tax law, such as enabling S corporations to hold any percentage of stock in C corporations. C corporations, however, are not allowed to own stock in S corporations.
Factors in Choosing Between an LLC and an S Corporation
The choice of business entity is going to be guided largely by the nature of the business and how the owner envisions the business unfolding and growing in the future. The general guidelines for making a choice are listed below.
A business owner who wants to have the maximum amount of personal asset protection, plans on seeking substantial investment from outsiders or envisions eventually becoming a publicly traded company and selling common stock will likely be best served by forming a C corporation, and then making the S corporation tax election. It is important to understand that the S corporation designation is merely a tax choice made to have your business taxed according to Subchapter S, hence the designation, of Chapter 1 of the Internal Revenue Service Code. All S corporations begin as some other business entity, either a sole proprietorship, a C corporation or an LLC. The business then elects to become an S corporation for tax purposes.
An LLC is more appropriate for business owners whose primary concern is business management flexibility. This owner wants to avoid all but a minimum of corporate paperwork, does not project a need for extensive outside investment and does not plan on taking her company public and selling stock. In general, the smaller, simpler and more personally managed the business is, the more appropriate the LLC structure is. If your business is larger and more complex, such as a multinational financial services firm, an S corporation structure is more appropriate.
Differences Between LLCs and S Corporations
The IRS is more restrictive regarding ownership for S corporations. An LLC is allowed to have an unlimited number of owners, commonly referred to as "members." However, S corporations are not allowed to have more than 100 principal shareholders or owners. S corporations cannot be owned by individuals who are not U.S. citizens or permanent residents, but non-U.S. citizens and non-U.S. residents are allowed to be members/owners in an LLC.
S corporations cannot be owned by any other corporate entity. This includes other S corporations, C corporations, LLCs, business partnerships or sole proprietorships. LLCs may be owned by any other type of corporate entity. LLCs also face substantially less regulation regarding the formation of subsidiaries.
There are significant legal differences in terms of formal operational requirements, with S corporations being much more rigidly structured. While LLCs are urged to follow the same guidelines, they are not legally required to do so. The numerous internal formalities required for S corporations include strict regulations on adopting corporate bylaws, conducting initial and annual shareholders meetings, keeping and retaining company meeting minutes and extensive regulations related to issuing stock shares. For LLCs, business operations are much simpler and the requirements are minimal.
For example, in lieu of the detailed requirements for corporate bylaws for S corporations, LLCs merely adopt an LLC operating agreement, the terms of which can be extremely flexible, allowing the owners to basically set up the business to operate in whatever fashion they most prefer. LLCs are not required to keep and maintain records of company meetings and decisions in the way that S corporations are required to do.
Differences also exist in basic management structure. The owners/members of an LLC are free to choose whether owners or designated managers run the business. If the LLC elects to have the owners occupy the company management positions, then the business operates more closely resembling a partnership. In contrast, S corporations are required to have a board of directors and corporate officers. The board of directors oversees management and is in charge of major corporate decisions, while the corporate officers, such as the chief executive officer (CEO) and chief financial officer (CFO), manage the company's business operations on a day-to-day basis.
Other differences include the fact that an S corporation’s existence, once established, is usually perpetual, while this is not typically the case with an LLC, where events such as the departure of a member/owner may result in the dissolution of the LLC. One area where LLCs typically face more stringent regulation than S corporations is that of transfer of ownership. Transfer of LLC ownership interests is usually only allowed with the approval of the other owners. In contrast, stock in S corporations is freely transferable.
Differences in accounting requirements also exist. One primary difference is that LLCs are typically required to use accrual accounting and are not allowed to opt for cash basis accounting, although there are some exceptions allowed. S corporations can choose either accounting option.
Making the Right Choice
LLCs are easier and less expensive to set up, and simpler to maintain and remain compliant with the applicable business laws since there are less stringent operational regulations and reporting requirements. Nonetheless, the S corporation format is preferable if the business is seeking substantial outside financing or if it will eventually issue common stock. It is, of course, possible to change the structure of a business if the nature of the business changes so as to require it, but doing so often involves incurring a tax penalty of one kind or another. Therefore, it is best if the business owner can determine the most appropriate business entity choice when first establishing the business.