S-Corp Or LLC?
Before you or your partners organize your startup, or reorganize an existing business, you will want to understand the basic similarities and differences between the three most utilized business entities: C corporations, S corporations and Limited liability companies (LLC’s). There are other business entities, such as limited and general partnerships and limited liability partnerships. However, for most small businesses with one or few owners, the S corporation or LLC presents the most appropriate choice of entity. Those startups seeking immediate private investment capital should strongly consider organizing as a C corporation.
No single structure will work best for all situations. The most appropriate choice depends on many factors, including the number of owners, the type of business, desired tax structure, whether or not it will be profitable right away and whether earnings will be retained or needed as capital. Please keep in mind that the information below, by itself, may not necessarily allow you to make the right choice. This should always be done in conjunction with your attorney and an accountant. With that having been said, the following guide only focuses on the three most commonly used business entities.
Most large companies and publicly traded corporations are “C” corporations. The “C” designation comes from Sub-chapter C of the Internal Revenue Code, which governs corporate taxation.
There are a variety of reasons C corporations are more aptly suited to large business. Using a C corporation allows multiple classes of stock and unlimited number of and types of shareholders. C corporations are primarily used for businesses who seek to raise capital publicly, or whose investors are numerous and diverse. In terms of ownership, shareholders own the corporation by virtue of owning stock (or shares) in the corporation. Corporations issue stock certificates to its shareholders to indicate ownership percentage in the corporation. Shareholders of corporations generally enjoy a complete liability shield from the acts or omissions of the corporation itself. The shareholders elect a board of directors, who then manage the business and affairs of the corporation. Usually a President, Secretary and a Treasurer must be appointed as officers of the corporation, although sole-shareholder corporations are permitted in most states.
C corporations are subject to double taxation. This means that the C corporation is taxed once at the corporate level, then those same revenues are taxed again at the shareholder level when profits are distributed via dividends (please note that in smaller C corporations, the double tax may sometimes be avoided by carefully zeroing out of net income each year by paying enough out to shareholder-employees). All corporations are automatically recognized as C corporations for tax purposes, unless the shareholder’s elect S corporation tax treatment (discussed below). The taxable income of the C corporations is taxable to the corporation itself and not the individual owners. (The corporation is taxed on income beginning at a corporate tax rate of 15% for the first $50,000 of taxable income each year, which increases up to 38% based upon tiers of corporate income).
Of course, there is state level income taxation on C corporations as well. If the corporation is classified as a “personal service corporation”, (PSC), the corporation will be liable for a 35% flat tax rate on all net profit. This is generally an undesirable entity type. PSCs are C corporations whose shareholders are engaged in the performance of personal services in the fields of accounting, actuarial science, architecture, consulting, engineering, health, including veterinary services, law, and the performing arts. A PSC is a C corporation by definition. Thus, a timely made S-election as discussed below would negate classification as a PSC and avoid the 35% flat tax rate.
Ownership– The biggest advantage of using a C corporation is the ability to accommodate numerous shareholders without restrictions on the amounts or types of shareholders. Also, C corporations are permitted to have different classes of stock, such as common and preferred stock. This means that it can create different distribution and voting rights among shareholders. Finally, shares may be freely transferred or redeemed without affecting the corporation. These are significant advantages for large businesses that want to raise capital publicly.
Fringe Benefits– Also, an advantage for small businesses is that the C corporation can deduct all of the premiums paid on behalf of shareholder-employees, or make reimbursements for benefits such as health and disability insurance. This compensation is not taxable to the shareholder-employees, unlike the owners of S corporations or LLC’s. This is a key tax advantage most beneficial to small businesses.
Taxation– The big disadvantage of C corporations is that retained earnings are subject to double taxation. This means the same profit stream is taxed at the corporate level and then taxed again when those profits are distributed to the shareholders. Also, if the business will have significant losses in the start-up phase, those losses can’t be passed through to the owner (they will carry forward and offset profits from year two). With an LLC or S corporation, losses can generally be passed through and deducted against other personal income.
Flexibility– Also, as you will learn, C corporations are far less flexible than LLC’s since distributions must be made according to each shareholder’s percentage interest and all rights accompanying a class of stock must be transferred along with the stock, unlike in an LLC where economic and voting rights can separately transferred.
Contributions– Another disadvantage lies with certain restrictions on the kind of contributions that can be made in exchange for stock under state law. As a corporation, owners may not be able to contribute future services or intangible property in exchange for an interest in the corporation in some states. This may pose problems for owners who seek to contribute some form of services to the corporation in exchange for stock during the start-up phase. But, many states do allow future services and intangible property to be contributed.
Liquidation– Another big disadvantage is the tax liability that can occur upon liquidation (dissolution) of the C corporation as opposed to being a sole proprietor or partnership. A C corporation that distributes appreciated assets to its shareholders must recognize gain on the distributions (generally subject to a federal income tax rate of 35%). In addition, each C corporation shareholder who receives the appreciated assets will also recognize gain on his or her receipt of such appreciated assets to the extent that the fair market value of the assets exceeds the shareholder’s tax basis in the stock. (However, a shareholder may be entitled to treat the gain as long-term capital gains). But, any appreciation in the corporation’s assets will be taxed at two levels essentially.
Asset Protection- The shareholders of a corporation are not protected against a creditor attempting to seize the shareholders stock in the corporation. The creditor will have all of the rights of the shareholder, including voting rights, since it will be able to attach any judgment to the shares owned by a debtor-shareholder. (However, a buy-sell agreement can be used to force a buy-back in such a situation). This poses a significant disadvantage compared to the LLC, as you will learn.
BEST FIT: C corporations are best suited for active businesses with a probability for significant appreciation and strong potential to offer shares publicly. C corporations generally retain their earnings in the beginning stages of growth and do not distribute earnings to shareholders in an effort to appreciate. C corporations typically have multiple owners or anticipate having a large number of shareholders. C corporations are also a good fit for growing your business when you need to maximize cash flow to finance equipment additions and grow levels of inventories and receivables.
An “S” corporation is a corporation, just like a C corporation. Its shareholders enjoy the same general shield from personal liability for the corporations’ acts or omissions. The main differences lay in the tax structure of both entities and with certain restrictions on ownership.
S corporations are far less flexible than C corporations and LLC’s. Only a limited number of shareholders (no more than 100) and only non-foreign individuals, estates and certain grantor and qualified trusts are allowed. In this sense, S corporations are typically more suitable for small and closely held businesses who do not seek to raise large amounts of capital publicly. As with a C corporation, shareholders own the corporation by virtue of their stock in the corporation. However, there can only be one class of stock in an S corporation, unlike a C corporation.
There is no federal corporate income tax on S corporations. Some states impose taxes on income on S corporation profits (i.e. “replacement taxes”) and this can vary from state to state. S corporation status is achieved by electing such tax treatment after organization (IRS Form 2553). Net profit or loss after expenses for S corporations, including salaries paid to employees and shareholder-employees, is reported on federal Form 1120S and this income (or loss) is “passed through” to shareholders’ personal tax returns via Schedule K-1. (Additionally, pass-through losses are limited to the taxpayer’s basis in the stock of the S corporation). Distributions of profits from the S corporation are subject only to the shareholder’s ordinary income tax rate (or even capital gains depending on the individual shareholder’s basis) and avoid self-employment taxes.
However, all wages are subject to payroll taxes. S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The S corporation will pay the employer’s share of FICA taxes (7.65%), and the employee will pay the other share of FICA taxes (also 7.65%). Between the S corporation and the shareholder, wages are subject to approximately a combined 15.3% payroll tax, plus the shareholder’s income tax rate. So all things considered, the shareholder-employee should pay as little salary to themselves as is permitted in order to decrease the amount of taxes paid on corporations’ profit stream. But, IRS rules do require that reasonable salaries must be paid to shareholder-employees (the failure to do so is considered by many to trigger an internal audit).
When do you need to pay wages? According to the IRS, reasonable compensation is determined by what the shareholder-employee did for the S corporation. The IRS will look at the source of the S corporation’s gross receipts: 1) services of shareholder, 2) services of non-shareholder employees, or 3) capital and equipment. If the gross receipts and profits come from items 2 and 3, then no compensation needs to be paid to the shareholder-employee. However, if most of the gross receipts and profits are associated with the shareholders personal services, then most of the profit distribution should be allocated as compensation. (Of course, you should ask an accountant for more details).
Even if income is not distributed to the shareholders and left as operating capital, it will still be taxable to the individual shareholders. This is because all income is passed through to the shareholders automatically. Shareholders in a C corporation are only liable for taxes on dividends they actually receive (but, undistributed income of the corporation is not subject to self-employment taxes).
Taxation– The major difference lies in the tax treatment of the S corporation. As stated, C corporations are subject to taxation at the corporate level and the shareholders are then subject to taxation on that same stream of revenue when distributed in the form of dividends. By contrast, S corporations avoid double taxation since only the individual shareholders are taxed. Also, since the profit distributions outside of wages are treated as passive income and are not subject to self-employment taxes, this can present a big tax advantage over partnerships/LLC’s, as discussed.
Flexibility– You lose a ton of flexibility with an S corporation, even more so then with a C corporation. There can only be one class of stock (common stock) and multiple restrictions on who can own shares of the corporation, as stated. The owners are not free to distribute profits and losses and handle economic and voting rights any way they see fit. Profit distributions must be made according to the shareholder’s percentage interest in the corporation. Further, you cannot create separate classes of distributive interests and separate economic and voting rights since only class of interests is allowed. Although there can be voting and non-voting common stock.
Contributions– Same as the C corporation.
Fringe Benefits– A significant disadvantage for small businesses is that an S corporation cannot provide as many tax-free fringe benefits to shareholder-employees as traditional C corporations. For instance, accident and health insurance premiums paid or reimbursed by an S corporation on behalf of shareholders owning more than 2% of the corporation are considered as taxable compensation to the shareholder-employee. The S corporation is not entitled to deduct the costs of these employee fringe benefits as expenses since these payments or reimbursements are considered compensation and are included as compensation for income tax withholding purposes on the shareholder-employee’s W-2 (but this compensation is not subject to payroll taxes).
Many other fringe benefits paid or reimbursed by the S corporation on behalf of the shareholder-employees are considered as compensation and are taxable to the shareholders. Although a few important benefits are exempt, such as corporation payments toward qualified retirement plans, and you should be sure to ask your accountant for more details.
Liquidation– Similar to the C corporation, if the corporation has been an S corporation from its inception, or elected S corporation status more than ten years prior to the liquidating distribution, the corporation is still required to recognize gain on its distribution of appreciated assets as a liquidating distribution to its shareholders. However, this gain will be “passed-through” to the shareholders and reported on their individual income tax returns.
Asset Protection– Same as the C corporation.
Tax Returns– The corporation has to file a separate federal and state tax return unlike for single-member LLC’s, even when there is only one shareholder.
Unemployment Taxes– Corporations are liable for state unemployment tax contributions. In Illinois, at least, LLC’s are not liable for such contributions.
BEST FIT: S corporations are generally suitable for active businesses with little debt, no high risk assets such as real estate and low chance for substantial appreciation since all corporate earnings are typically distributed to the shareholders. If the business will make a profit in excess of what amounts to a fair salary to owners, an S corporation is an ideal tax structure. The S corporation is ideal for most small businesses.
Limited Liability Company (LLC)
An LLC, or limited liability company, offers the same personal liability shield to each of its owners that a corporation offers. The LLC is essentially an organized partnership offering the same protections as corporations, but with much more flexibility.
The LLC’s owners are called members and each Member owns a percentage of the LLC by virtue of owning a Membership Interest in the company. Similar to C corporations, LLC’s may create differing classes of membership interests. Members can include corporations and other LLCs, providing ultimate flexibility in ownership structure with this entity. An LLC is usually member-managed, where the business and affairs of the LLC are managed by the members themselves, or can be a manager-managed LLC where either a member-manager or an outside manager is appointed instead. Most small business LLCs are usually member-managed. Most states allow single member LLC’s.
Tax Treatment: The LLC is taxed as a partnership as profits and losses are “passed through” to the members and there is no entity level income tax. The LLC avoids double taxation then just like the S corporation. (Again, some states do impose replacement taxes on the income of LLC’s). The LLC income is reported on Form 1065 and then distributed to owners via Schedule K-1. The owners then report this income on their individual returns (1040) on schedule E. If the LLC has only one owner, the IRS will automatically treat the LLC as if it were a sole proprietorship (a “disregarded entity”). A disregarded entity does not file a tax return and the owner reports the income through schedule C of his or her individual return. If the LLC has multiple owners, the IRS will automatically treat the LLC as if it were a partnership. However, an LLC is known as a “check the box” entity, meaning it may elect to be taxed as a corporation or as a partnership.
In terms of self-employment (payroll) taxes, there is a lot of confusion when it comes to LLC members. Whether a member of an LLC is treated as a general partner as opposed to a limited partner is significant in determining self-employment tax liability since an LLC is taxed as a partnership. If a member is treated as a limited partner, there is no self-employment tax on the member’s distributive share of LLC income. However, any “guaranteed payments” for services actually rendered to or on behalf of the LLC, will be subject to self-employment tax, to the extent that those payments are viewed as renumeration for those services (See 26 USC § 1402(a)). If a member is considered a general partner, he or she must pay self-employment taxes on the member’s share of distributive LLC income. But, there are not yet well-defined rules governing self-employment tax treatment of members of an LLC classified as a partnership for federal tax purposes.
Most accountants assume that the tax treatment of a managing member of an LLC is the same as that of a general partner in a partnership, and that the non-managing members are treated the same as limited partners. Generally, a managing member’s earnings and distributive income has been thought of as being subject to self-employment tax. But, the distributive income of the non-managing members has generally been excluded from being subject to self-employment tax. This treatment is based upon the 1997 Proposed Treasury Regulations Section 1.1402(a)-2(h)(2). That regulation states that if an LLC member is: i) personally liable for debts; ii) does have the power to bind the LLC to a contract; or iii) does provide more than 500 hours of service per year to the LLC, the member will be taxed as a general partner and will have self-employment tax obligations on LLC income allocations. Otherwise, the member will be taxed as limited partner.
Please note that the 500 hour test does not apply to LLC’s engaged in professional services, such as medicine, law, engineering, architecture, accounting, actuarial science or consulting. For those LLC’s, no member who provides more than a de minimis amount of services to the LLC can qualify for treatment as a limited partner for self-employment tax purposes. Since the 1997 proposed regulation, it has neither been adopted as law or clarified by the IRS. However, the proposed regulation can be relied upon to avoid a penalty under IRC section 6406(f). Also, there is judicial precedence to reasonably conclude that the court will uphold the position of a taxpayer who relies on the regulation. (See Elkins, 81 T.C. 669 (1983)). IRS representatives have also since stated that the 1997 proposed regulation can be relied upon.
Finally, it is possible that the LLC will have two classes of interests, one of which is treated as a general partnership interest and one of which is treated as a limited partner interest. If a partner or a member owns interests of both classes, then the member will be able to allocate his or her income allocations between the two classes and will be required to pay self-employment taxes on the general partner portion, but not on the limited partner portion.
Flexibility– The LLC provides significant flexibility in terms of allocation of profits and losses to its owners. Specifically, an LLC can allocate profits and losses among its members in order to minimize the overall tax burden of its members. For example, assume you and your partner own an LLC to which you contributed $80,000 in capital and your partner only contributed $20,000. If your partner performs 80% of work, the owners could still decide to split the profits 50/50. However, if you and your partner were shareholders in an S corporation, you would be required to distribute 80% to you and 20% to your partner by law. This can be an inequitable way to structure your business if you have any partners. Different classes of interests can be created with rights to receive distributions only or preferred distributions.
Another significant benefit is the ability of the members to limit a transfer of a membership interest to a transfer of an economic interest only. This means future members can be restricted to receiving distributions (and paying taxes on those distributions) but with no accompanying voting or management rights. When a shareholder of a corporation transfers his or her stock, all attributes of ownership including voting rights accompany the transfer, unless the stock is non-voting stock. Furthermore, without the consent of the members of an LLC, no transferee of a membership interest becomes a substituted member, only an assignee. This is significant since, by law, the assignee has no rights of a member under the operating agreement.
Contributions– In many states a shareholder cannot contribute future services or intangible property in exchange for shares in the corporation. Members of an LLC can generally contribute cash, property or services upon formation or in the future, as they see fit, or no contribution at all in some cases.
Fiduciary Duties- Another significant difference of an LLC is the ability to give much more flexibility in setting the fiduciary duties owed by managers or members to the LLC. Members of an LLC cannot eliminate or reduce fiduciary duties in most states, but they can determine the standards by which these duties are measured (provided these standards aren’t unreasonable). The members can generally identify and list certain activities that do not violate fiduciary duties and the approval procedure. This isn’t possible with a corporation as directors and officers owe fiduciary duties to the corporation and the shareholders in some states. (But, some states, such as Delaware and Texas, do permit corporations to have an exculpatory provision in the Articles of Incorporation absolving corporate directors of liability for suits brought on behalf of the corporation for violations of the duty of care. I discuss fiduciary duties in more detail later in this Chapter).
Asset Protection– The partners are protected against a creditor attempting to seize the partner’s interest in the partnership. A creditor of a partner can generally only obtain a “charging order” against the partner’s economic interest in the partnership. But, the creditor cannot obtain any other rights of a partner, including the right to force a distribution from the partnership or dissolution of the partnership. Sometimes, the creditor has to even pay taxes on the partner’s share of the partnership income even though it cannot force a distribution of cash! This partnership protection is referred to as charging order protection.
Liquidation– In comparison to the corporation, merely winding up (liquidating) a sole proprietorship or partnership and distributing appreciated property is generally non-taxable to the partners (however, there are exceptions and you should talk to an accountant to learn more.
Tax Returns– One underrated advantage of single-member LLC’s is that they are considered as disregarded entities for federal and state income tax purposes. LLC taxes flows through to the single-member. This means single-member LLC’s don’t file separate tax returns like corporations.
Unemployment Taxes– In Illinois (and most states), LLC’s are treated the same way they are treated at the federal level. This means LLC’s are not required to pay unemployment tax contributions at the federal or state level. However, if the LLC elects to be treated as an S-corporation, then the LLC will become liable for such contributions.
Taxation– Owners of the LLC must pay self-employment tax (payroll taxes) to the extent they are receiving compensation for services provided to the LLC and are considered general partners. Remember, in an S corporation, only the wages, and not the distributions to shareholder employees, are subject to self-employment taxes. Thus, electing to be taxed as an S corporation can provide significant tax savings to its shareholders in contrast to the LLC in some instances. However, an LLC can elect to be taxed as an S corporation, assuming it is eligible for S corporation status, and reap the same tax benefits, as I discussed. Also, the IRS treats each LLC member as though he/she receives her entire distribution share each year. This means that each LLC member must pay taxes on their distribution share whether or not the LLC actually distributes the money out to the members. Even if LLC members need to leave profits in the LLC to buy products or expand the business, each LLC member is liable for income tax on their share of that money.
Fringe Benefits– Also, the same rules regarding deductions for important fringe benefits apply as in the S corporation including health, accident and life insurance premiums. This means the members of an LLC will be taxed on the payments made towards insurance premiums and other fringe benefits just like the S corporation shareholders.
BEST FIT: Real estate investments, holding companies owning equipment and investment assets and businesses owning other assets involving a risk of liability are generally appropriate for LLC’s. Of course, if you have one or more partners and want to be flexible with how the business distributes profits (and losses) and other allocations to the owners, then the LLC is almost certainly the best choice.