Whether you’re just starting a business or thinking of changing your business structure, a common first step is comparing the LLC vs. the S corporation. While a limited liability company and an S corporation share some characteristics, they also have distinct differences. Get familiar with each before deciding which might be right for you.
The similarities of LLCs and S Corps
LLCs and S corps have much in common:
Limited liability protection. The owners of LLCs and corporations are not personally responsible for business debts and liabilities. Instead, the LLC or the S corp, as the owner of the business, is responsible for its debts and liabilities.
Separate entities. Both are separate legal entities created by a state filing. However, they are formed under and governed by very different state business entity statutes
Pass-through taxation. Both are pass-through tax entities. (Although an LLC can choose not to be taxed as pass-through if the owners so choose). With pass-through taxation, no income taxes are paid at the business level. Business profit or loss is passed through to owners’ personal tax returns. Any necessary tax is reported and paid at the individual level.
Ongoing state compliance requirements. Both are subject to certain obligations imposed by the state corporation and LLC statutes, such as having to appoint and maintain a registered agent, filing annual reports and paying annual fees, notifying the state of changes such as a change of name, registered agent, or entity type and having to qualify to do business in states outside of the formation state.
Differences in ownership and formalities
Ownership. The IRS rules restrict S corporation ownership, but not that of limited liability companies. IRS restrictions include the following:
LLCs can have an unlimited number of members; S corps can have no more than 100 shareholders (owners).
Non-U.S. citizens/residents can be members of LLCs; S corps may not have non-U.S. citizens/residents as shareholders.
S corporations cannot be owned by corporations, LLCs, partnerships, or many trusts. This is not the case for LLCs.
LLCs are allowed to have subsidiaries without restriction.
S corporations cannot issue classes of stock with different financial rights – such as giving some shareholders a preference to distributions over other shareholders. LLCs are not subject to similar restrictions.
Ongoing formalities. Corporation laws have more mandatory requirements regarding how a corporation is to be managed than LLC laws. Therefore, S corporations face more extensive internal formalities. While LLCs are not required to, some advisers recommend that they too follow internal formalities.
Required formalities for S corporations include: Adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings, and keeping meeting minutes with corporate records.
Recommended formalities for LLCs include: Adopting an operating agreement, issuing membership shares, holding and documenting annual member meetings (and manager meetings, if the LLC is manager-managed), and documenting all major company decisions.
Differences in management
Owners of an LLC can choose to have members (owners) or managers manage the LLC. When members manage an LLC, the LLC is much like a partnership (or a sole proprietorship if there is only one member). If run by managers, the LLC more closely resembles a corporation as members will not be involved in the daily business decisions.
S corps have directors and officers. The board of directors oversees corporate affairs and handles major decisions but not daily operations. Instead, directors elect officers who manage daily business affairs. Shareholders do not manage the business and affairs.
Other differences between LLCs and S Corps
Other differences between S corps and LLCs include:
Transferability of ownership. S corporation stock is freely transferable, as long as IRS ownership restrictions are met. An LLC membership interest (ownership) typically is not freely transferable—approval from other members is often required. (Although the members may provide otherwise in their operating agreement if they wish.)
Self-employment taxes. S corporations may have preferable self-employment taxes compared to the LLC because the owner can be treated as an employee and paid a reasonable salary. FICA taxes are withheld and paid on that amount. Corporate earnings after payment of the salary may be able to be treated as unearned income that is not subject to self-employment taxes. For more information and whether this might apply to your particular situation, please contact your accountant or tax adviser.
Allocation of profits and losses. S corporation shareholders receive their profits and losses based on their percentage of ownership (e.g. a 50% shareholder receives 50% of the profits and losses). LLCs can allocate profits and losses on almost any basis they want (e.g. a member with a 50% ownership interest could be entitled to 90% of the profits and losses).
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