Entity Selection: LLCs and S-Corporations

A common question facing entrepreneurs is whether to organize their business as a limited liability company (“LLC”) or S-corporation (“S-corp”).  While there is no one-size-fits-all answer, in this post, I highlight some of the features of LLCs and S-corps, setting forth some factors that may influence your decision.

Both LLCs and S-corps are limited liability vehicles, meaning they protect an individual owner’s assets from creditors of the business.  

• Both LLCs and S-corps are taxed as pass-through entities for federal income tax purposes, meaning there is no tax imposed on the entity, but that income and losses of the business are passed through to the owners.  That being said, some states do impose taxes on S-corps.

• In either an LLC’s operating agreement or an S-corp’s buy-sell agreement, it is easy to provide for or restrict the future transfer of ownership interests to outside parties.  

• LLCs are generally easier and less expensive to form than S-corps and are much more flexible in terms of management structure and day-to-day operations, making them less expensive to maintain.  S-corps must adhere to corporate formalities regarding the election of directors and officers, the holding of annual meetings, and the issuance of stock.  

• There are several restrictions imposed on S-corps that do not impact LLCs, as follows:

           o   S-corps may only have certain types of shareholders (individuals, certain 
                estates and trusts, and certain tax-exempt organizations) 
           o S-corps cannot have more than 100 shareholders
           o An S-corp may only have one class of stock issued and outstanding (although 
                there may be voting and non-voting shares within the class)
           o An S-corp cannot disproportionately allocate its profits and losses among 
                shareholders; for example, if a shareholder holds 10% of the shares, he must 
                be allocated 10% of the profits or losses.

           Some entrepreneurs are dissuaded from organizing as an S-corp because such
           restrictions may deter third-party investors; on the other hand, many 
           investors prefer the formalities and structure of the corporate form.

• Owners of an LLC must pay self-employment tax on all income generated by the LLC, whereas S-corp owners are only subject to self-employment tax on their actual salaries (which must meet a “reasonable” threshold).  Any additional distributions received by an S-corp owner are treated as dividends, which are taxed at a lower rate and may therefore result in a lower overall tax liability.

Generally speaking, first-time business owners, Internet businesses, and small service businesses (i.e., one or two-owner retail, design, advertising, and architectural businesses) elect to organize as LLCs, whereas fast-growing businesses looking to either attract outside investors or eventually provide employees a right to ownership choose to form as an S-corp (or a C-corporation, which is not discussed here).  In the event you do choose to form your business as an LLC but later decide that an S-corp is preferable, conversion is an option.

Remember that the LLC and S-corp rules may vary significantly from state to state, and this is merely a summary of some key features of each.  Before starting a business, you should consult with both your attorney and accountant, who can advise you as to which path best suits your needs.