If you’re in the process of starting a business, one of the decisions you’ll have to make is choosing an entity type. This decision will impact the structure of your business, as well as how it’s taxed. Two options available to you in this scenario are forming a limited liability company (LLC) or forming an S-corporation.
Both entity types provide limited liability protection, which helps to shield off the personal assets of owners. Limited liability protection ensures that owners cannot be found personally liable for the debts of the business. In this way, the liability of the owners cannot exceed the amount of money that they’ve invested in the business.
Another similarity between LLCs and S-corporations is the manner in which they’re taxed. Both entities enjoy “pass-through” taxation, meaning that the profits from their business pass through to the members. These members then report the earnings on their own individual tax return, thus avoiding the double-taxation that C-corporations face.
Note, however, that a subtle difference may apply in which LLC distributions are subject to employment tax, whereas S-corporation dividends are not. Additionally, it should be noted that LLCs do have the option of electing to be taxed as a C-corporation.
While both an LLC and S-corporation have liability protection and pass-through taxation in common, the two entity types have a few notable distinctions between them. We’ll go over these differences here to give you a sense of which option is best for your business.
LLC vs. S-Corp: Ownership
An important aspect to consider for your business is how ownership structure differs between these two entity types. S-corporations issue stock to shareholders to determine ownership. The amount of stock that a shareholder owns in the corporation dictates that shareholder’s ownership percentage.
Note that S-corporation shareholders must be US citizens or permanent residents and cannot be corporations or partnerships. Additionally, the number of shareholders cannot exceed 100 and the S-corporation can only issue one class of stock.
An LLC, on the other hand, has more flexibility in how it distributes ownership. LLCs can determine ownership share beyond simple financial investment in the company. For example, even if one member invested less in the LLC than another did, that member could receive an equal distribution of profits if the company’s operating agreement stipulated an equal share among all members.
Another difference is that corporations, trusts, and foreign individuals can own an LLC, which again offers more ownership flexibility when compared to an S-corporation.
LLC vs. S-Corp: Management
Also consider what type of management structure would work best for your business, as LLCs and S-corporations differ in this regard. LLCs have the option of being member-managed or manager-managed. A member-managed LLC means that the owners of the LLC manage the day-to-day operations, while a manager-managed LLC means that a non-owner is brought in to run operations.
S-corporations, on the other hand, are a bit stricter in nature when it comes to management. Corporations must appoint a board of directors to oversee management responsibilities and shareholder interests. The board can then appoint officers to manage various day-to-day operations within the business.
While shareholders are not involved in the daily decision-making and operations of the business, they do have the ability to elect the directors and officers that are involved in these aspects. Also note that shareholders can be appointed to serve as a director or officer.
LLC vs. S-Corp: Reporting Requirements
It’s also important that you keep the reporting requirements for each entity type in mind as you consider your choice. Both entities have reporting requirements that they must fulfill with the state in which they’re formed. Keeping up-to-date with these requirements keeps your business in good standing with the state.
Requirements for corporations include an annual shareholder meeting in which documentation of the discussion is recorded, also known as corporate minutes. Any changes set to take place must receive a majority vote by the shareholders. Also, corporations are typically required to file annual reports with the Secretary of State.
In general, LLCs have fewer reporting requirements than corporations, as they’re not required to appoint a board of directors, keep corporate minutes, or hold an annual shareholder meeting. Some states do not even require that LLCs file an annual report with the Secretary of State.
LLC vs. S-Corp: Final Thoughts
If you’re trying to decide between an LLC and an S-corporation for your business, remember that both entity types offer their members and shareholders limited liability protection. Additionally, in terms of taxation, each entity enjoys the pass-through classification, which avoids the double taxation that occurs at the corporate level.
Generally, LLCs are preferred by businesses that favor more flexibility, owner-managed operations, and less formal requirements. While corporations are preferred by businesses that favor set structure and are seeking outside investors.
If you’re not entirely certain about which business structure would work best for your business consider seeking the advice of an attorney or CPA. An expert that is well versed in forming LLCs and corporations can answer any questions you may have, including those related to taxes, ownership, and more.