As attorneys who often help small business clients form the entities under which they operate their various businesses, we are often asked whether they should form a limited liability company (LLC) or a corporation, specifically an S corporation (S corp). Most clients know that unlike partnerships or sole proprietorships, LLCs and S corps are entities that will generally shield them from personal liability for the acts and/or omissions of the business. However, relationships between owners, management responsibilities, tax treatment and profit and loss allocations are just a few of the factors that will dictate which choice of entity is right for their business. Generally, there is no uniform “right” choice. A careful review of the details, strategies and goals of each business needs to be made before the entity is chosen. There are, however, some basic similarities and differences between each entity. I have attempted to provide an overview of some of the key elements below. It is important to keep in mind, the information below, by itself, will not allow you to make a proper, informed choice of entity for your business. This should always be done in conjunction with your attorney and accountant.
S corps and LLCs are similar in that they are both “pass-through” entities for tax purposes. The income generated from these companies are passed through to their member or shareholders as the case may be, thereby eliminating the double taxation incurred by owners of a standard corporation, or C corporation. In this regard, both S corps and LLCs are both preferable over a C corp as a C corp’s profits are taxed once at the corporate level and then again when the remaining profits are distributed as dividends to its shareholders who must then pay income tax on the dividends.
Owners of a Business Entity
There are no limitations on who can be a member (i.e. owner) of an LLC. Any individual or entity can be a member of an LLC. Only individuals, other than non-resident aliens, certain estates and trusts, charitable organizations and qualified retirements plans can be shareholders of an S corp. Thus, an S corp cannot have as a shareholder a nonresident alien, a corporation, a partnership or an LLC as a shareholder. Additionally, S corps are also limited to no more than 100 members, while LLCs have no limits as to the number of members it may have.
Allocations of Income and Losses
An LLC provides significant flexibility in terms of the treatment of capital contributions and the allocation of profits and losses to its members. Specifically, an LLC can distribute profits in the manner its members see fit. Shareholders of an S corp however must distribute profits in proportion to their stock ownership percentages. Each share of an S corp must be treated the same as every other share with respect to allocations. For example, assume Madeline and Mia own an LLC to which Madeline contributed $75,000 in capital and Mia only contributed $25,000. If Mia performs 75% of work the members could still decide to split the profits 50/50. If these same partners owned an S corp, Madeline would be required to take 75% of the profits and Mia only 25%.
The management of an LLC can be performed by the members or the members may elect to have a manager run the day to day operations of the company. Conversely, the shareholders of an S corp elects directors who oversee the affairs of the corporation and has responsibility for major decisions. The directors in turn elect officers who manage the daily affairs of the business.
There are a myriad of other important similarities and differences between S corps and LLCs which are beyond the scope of this article. Again, prior to starting a new business, you should first consult with both your attorney and accountant, professionals who can more fully explain the important factors to be considered to ensure the entity you are choosing best fits your business model.