S Corp Versus LLC: Which Structure Is Better?
If you are a young startup business, you may be wondering how to structure your company. Like many business owners, your head may be swimming with ideas, as you compare sole proprietorship, C Corp, S Corp, and LLC structures.
Which legal entity you choose can have widespread ramifications for your business, including liability, taxation, financing, growth, shareholders, and operational policies.
Let’s take a look at two of the most popular formats, S corp and LLC, to see how they compare and let you determine which one is better for your company.
What Is an S Corp?
Also known as an S subchapter or S corporation, an S corp is a type of business as determined by the United States Internal Revenue Service (IRS). There are certain criteria for an S corp, which every business must satisfy in order to retain this type of classification:
Must have 100 shareholders or less
Must have no more than one class of stock
Must not have a shareholder that is a nonresident alien.
In essence, S corp status allows a business to incorporate while being taxed like a more informal partnership. We’ll get into the specifics of this as you read on.
What Is an LLC?
LLC stands for Limited Liability Company. An LLC is considered a hybrid legal entity that has some characteristics of a corporation as well as those of a sole proprietorship or business partnership.
Limited liability companies are subject to state statutes. Therefore, the subtleties of LLC regulations can vary from state to state. The biggest benefit of an LLC is, as the name implies, the liability of the owners (also known as members) is restricted when it comes to the business’s liabilities and debts.
What Do S Corp and LLC Structures Have in Common?
Protection of Personal Assets Through Limited Liability
Similar to LLCs, S corporations also limit the liability of business owners with regard to business debts and liabilities. What does this mean on a practical level? If someone sues you, for example, they cannot go after your personal assets to pay a debt or a judgment in a lawsuit.
Many business owners appreciate this kind of protection. If you have a family, you know you won’t lose your house to pay a debt. Should you be lucky enough to have inherited a large sum of money, you won’t lose it to a court decision in another party’s favor.
Both LLCs and S corps use what is known as pass-through taxation, although this is not mandatory for an LLC. This tax structure means that income taxes are not paid at the business level. Instead, profit and loss are passed through to the business owners’ personal tax returns. If taxes must be paid, individuals pay them, not the business.
State Compliance Requirements
As mentioned previously, if you form an LLC, you will need to adhere to various requirements set by your state, which can vary by location. S corps also need to follow certain state obligations.
Depending on where you operate, you may be required to:
File an annual report
Pay annual fees
Appoint a registered agent
Notify the state of significant changes to your business
Qualify to do business outside your company’s formation state
Where Do S Corp and LLC Structures Differ?
While S corps and LLCs clearly have much in common, there are also major differences between the two. You should study these differences carefully when deciding which structure best suits your business.
The IRS is more restrictive of ownership when looking at S corps than at LLCs. Since shareholders are owners, and since S corps can have no more than 100 shareholders, they may only have 100 owners. LLCs have no limits to the number of owners (members) they may have.
Furthermore, S corps cannot have nonresident aliens, LLCs, partnerships, corporations, or certain trust as owners or shareholders. There is no such limitation, however for LLCs.
LLCs are not restricted when it comes to giving preferential stock distribution (giving some shareholders a preference over others). S corps, though, must give all shareholders the same class of stock with the same financial rights.
S corporations, unlike LLCs, are required to use certain formalities when it comes to management. They must, for example:
Hold shareholder meetings
Keep meeting minutes
It is recommended that LLCs adopt formalities such as creating an operating agreement, holding member meetings, and the like. However, they are not strictly required to do so.
S corporations use directors and officers to run their businesses. The board of directors makes all major decisions and hands down daily operations to officers. Shareholders never manage business affairs.
In contrast, LLCs can have members (owners) in any level of management, from the top down. This makes sense when you think about many LLCs being simply two or three people. As LLCs grow, they often more resemble S corps in their management structure.
S corp ownership (stock) is freely transferable, within the rules set forth by the IRS. However, a member of an LLC cannot transfer ownership without the approval of other members, unless this has been previously allowed by the operating agreement.
When it comes to taxes, S corps may be in a more favorable position than LLCs. With an S corp, the owner may be considered an employee, paid a salary, and taxed on that salary. Corporate earnings outside of the payment of the salary may be considered unearned income and therefore not subject to self-employment taxes.
Profit and Loss Allocation
LLCs can divvy up profits and losses however they like. For example, a partner who owns 50 percent of the business’s interest could reap 80 percent of the profits--not an unlikely scenario if that person founded the company or invented an item around which the business was created.
As you might imagine, an S corp handles profits and losses completely differently. Each shareholder is rewarded (or punished) according to the percentage of shares they own in the business.
Which Structure Is Right for Your Business?
So, after reading through the above, do you have a better picture of whether an S Corp or LLC is best for your startup business? If you’re still on the fence, here are some questions to ask yourself:
How much flexibility do you need for your business? If maximum flexibility is your goal, an LLC may be better for you.
How large and complex is your business? If your business is already sizable, you may want to go with an S corp.
What is your vision for your business? You may be small and simple now, but if you are seeking large amounts of outside financing or intend to grow soon, an S corp may be the best solution.
Do you have owners or want to have owners internationally? That rules out an S corp and points you in the direction of an LLC.
What do your state laws say regarding each type of structure? That might be a deciding factor in choosing a structure.
Some businesses may be tempted to go the LLC route out of convenience, fearing the manpower and the paperwork that is required to form and maintain an S corp is beyond them. But this can be a mistake with enormous consequences that are completely avoidable.
If your young business isn’t fully staffed yet, or if you are unsure how to go about providing all the documentation you need for your new business, regardless of which structure you prefer, consider outsourcing your accounting and CFO needs.
Scrubbed is available to help you with both day-to-day operational accounting and larger financial needs, such as requirements for structuring your business, paying taxes, managing operations, and seeking financing. You can hire Scrubbed for as long as you need--from a few months to a few years--and we have multiple pricing tiers to suit every business’s unique criteria.
We offer turnkey business services including, but not limited to, all of the following:
Accounting and financial reporting
Inventory management support
White label accounting
Audit and professional services
Tax preparation and filing
Corporate finance services
Scrubbed is happy to offer your business a free consultation to see how we can help with structuring your business and keeping it on track. We can look at where you are now and where you want to be one year, two years, and even five years from now to help you choose the right structure for your enterprise. We can take the headache out of maintaining a complex business by taking on accounting tasks and letting you do what you do best.
Don’t wait too long to set up your startup business the way it should be. And don’t let the complexities of starting or managing your business within the proper framework deter you from the right structure. Contact Scrubbed today.
About The Author:
Raiza specializes in tax compliance and planning for businesses and individuals. She has over 9 years experience in handling Tax Return Preparation, Tax Provisioning, Tax Planning, and setting up Tax Workbooks. She also specializes in Sales and Use Tax Return Filings, Other State and Local Tax Compliance Requirements, Reviewing IRS and State Department Notices and guiding clients for compliance.