Wednesday, July 27, 2011

LLCs vs. S-Corporations

Last year I wrote a post about the benefits of using an LLC with an S-election as a business owner to limit employment taxes. The question I received in response was, why not just use a corporation instead?

An LLC is a state-created entity. The IRS doesn't recognize it as a specific taxable class and requires you to elect how it should be taxed or the IRS will give it default tax treatment based on the number of owners. I explained the benefits of choosing to be taxed as an S-corp in the post referenced above. So what's wrong with just creating an S-corp from the start? That depends on what you're looking for.

If you want simple maintenance, the LLC is the way to go. Maintenance, in this context, refers to keeping the formalities necessary to maintain corporate status. Losing corporate status means losing the veil between you as an individual and you as a business owner. That translates to personal assets and business assets being vulnerable in a lawsuit against either the individual or the business. Corporate formalities include naming a board of directors, performing meetings of the directors and officers and maintaining meeting minutes. You will also need a stock ledger and stock certificates. An LLC requires none of these.

An LLC is also more flexible. In single member LLCs this is less important, but for partnerships, the operating agreement is much more malleable than the bylaws of a corporation. An LLC allows for adjustable distributions between owners whereas the corporation must distribute in amounts proportional to stock ownership. That means that if Adam contributes 10% of the capital and Bill contributes 90%, Bill must receive 90% of the profits, even if Adam does 90% of the work going forward. An LLC operating agreement can adjust this.

An S-corporation has its advantages too. Its easier to transfer stock to new owners than it is to transfer LLC ownership interest. The requirement of annual meetings can be beneficial by forcing the owners to discuss business beyond the day to day operation. This site provides a nice comparison matrix of the three types of entities discussed here. A C-corporation is extremely advantageous for a whole host of reasons that are beyond the scope of this blog post. Suffice to say, I very rarely recommend C-corps for small business owners

To conclude, I want to emphasize the importance of a competent CPA to advise your business. When I create a simple LLC for a client, I explain that the LLC is a pass-through entity, meaning that all LLC income is reflected directly on the individual's tax return. On the other hand, LLCs with S-elections and corporations come with a lot more explanation and encouragement to retain a CPA. The tax treatment is unique, the formalities are more involved and rules are more complex. A good CPA will attend to all of this, plus help take advantage of many additional corporate benefits not addressed here.

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