In my business law practice, at least once a week, someone asks me, “Should I choose an S-Corp over an LLC for my company?” Choosing your entity type is a critical choice and one that deserves some serious consideration. And there’s no one-size-fits-all solution.
Your entity selection will have a big impact on your exposure to liability as an owner, and it will also impact how much your company and you pay in taxes every year. It can also affect how you grow, how many owners or shareholders your company can have and how much money you can raise for your company.
There are three kinds of entities that are likely going to be the appropriate choice for your business: a Limited Liability Company (LLC), a C-Corporation (C-Corp) or an S-Corporation (S-Corp). Let’s explore the pros and cons of each.
C-Corp: A C-Corp is a traditional corporation. You can have unlimited shareholders and multiple classes of stock. You have unlimited fundraising options, can go public and get the benefit of a limit to personal liability for business activities. The big downside of a C-Corp is that net revenues are taxed twice (called “double taxation”): once on the corporate level and again on the individual shareholder’s tax return (for amounts distributed to that shareholder). Double taxation was viewed for many years as a huge burden for small businesses, which led to the formation of a new entity called the LLC.
LLC: An LLC is a fantastic choice for many business owners. It protects the business owner from the debts and liabilities of the business just like a C-Corp does, while also providing pass-through tax benefits, meaning that you avoid double taxation, as your net revenue is taxed only once on your individual income-tax level.
LLCs allow you to grow and add additional members as needed by your company, and you can issue different classes of ownership (in an LLC, that is called “membership”). So you can have non-voting and/or non-managing members of the LLC. That enables you to use equity when needed as you build your company.
But, and this is a big one: Not all debts and liabilities will belong to the LLC. Many young businesses obtain credit/loans by providing a personal guarantee for that debt. So if you provide your social security number or personal financial information to obtain financing or credit, you can bet that you will be personally liable for that debt, even if your LLC is unable to pay it back.
So what are the other downsides of an LLC? The main one is that if you intend to raise money or get investors, you will likely have to convert your LLC to a traditional C-Corp. But otherwise, an LLC is the easiest entity to set up, maintain and manage.
S-Corps: In the most simple terms, an S-Corp is a tax election. It arises when a business elects to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.
Before you can elect S-Corp status with the IRS, you must first start with some other entity form for your company (what I call the “underlying entity”). In other words, you must start out as either a sole proprietorship or a partnership (if you have more than one founder), traditional C-Corp or an LLC. Only then will you make the S-Corp election.
A business owner might choose to be taxed as an S-Corp because it provides the same pass-through taxation as an LLC and has some additional tax benefits. The S-Corp form can save a business owner a large amount in self-employment taxes every year, something that cannot be said of the LLC, where every penny of revenue is subject to self-employment tax.
The S-Corp is looking pretty good right about now, isn’t it? But before you choose this entity, please run — don’t walk — to your favorite CPA and discuss whether it is the right choice for your situation.
There are some heightened requirements the business owner must satisfy yearly in order to maintain the S-Corp status. For example, the shareholders must (I repeat, must) adhere to corporate formalities, including holding regular and special meetings, keeping minutes of those meetings at the corporate headquarters and using a formal, written corporate resolution to document every single significant decision made on behalf of the organization by those running it. Failure to maintain corporate formalities can result in a host of significant tax ramifications, including facing double taxation and possible back taxes and penalties if your underlying entity is a C-Corp, and also being barred from using the S-Corp election again for five years.
The other little-known truth about S-Corps is that you will only really begin to see the financial benefits of it once your revenue is in the solid upper six figures. Remember to talk to your CPA about whether your company will truly benefit from this election because many do not.
A few other considerations to weigh: There are serious limitations on the number of shareholders an S-Corp can have, and you can only issue one class of stock to shareholders. Furthermore, your shareholders cannot generally receive special allocations of profits and losses, which may make it more difficult to raise capital through investors.
So, What’s The Best Option?
Even though an LLC is not the ideal fundraising vehicle, for many business owners, its advantages outweigh the S-Corp’s. For example, with an LLC, business debt generally increases the membership tax basis, meaning that members can deduct more losses from the business on their individual returns. And the higher the investor or member’s basis, the less capital gains are possible, which ultimately means less tax when she sells her interest or sells the business. So, although the S-Corp provides the benefit of lower self-employment taxes for its members, an inability to utilize business losses and debts could easily offset the benefit of having a smaller self-employment tax. And once you factor in its other limitations, the S-Corp will only be the right choice for a select group of businesses. When in doubt, you can’t go wrong with an LLC.
Regardless of which entity you choose, remember to consider state-specific tax information. Consult a local attorney (or an attorney in your jurisdiction of choice, such as Delaware) to determine which entity is ultimately the right one for your business.
To get more information about the author, Jessica Eaves Mathews, please see http://www.jessicaeavesmathews.com.