If you’re starting a business with multiple shareholders investing significant amounts of money in the start-up, you may want to incorporate the business into a S corporation or choose to start a Limited Liability Corporation or LLC. Each business structure has specific advantages that may make it more appealing to the other for certain shareholders.
An S corporation allows business owners to avoid double taxation because it does not require the business to pay corporate income tax on company profits. Instead, all profits go directly to shareholders, who pay taxes on their individual income taxes. Also, owners of S corporations are given liability protection, meaning they’re not personally on the hook for liabilities the S corporation may incur such as debts or lawsuit judgments.
LLCs are a sort of hybrid between corportions and partnerships, offering liability protection and pass-through taxation. LLCs are less bound by corporate rules than S corporations.
LLCs are a relatively new innovation in business structure and prior to their creation, the only way owners of a business could get liability protection was to form a corporation. Many businesses that would have been S corporations in the past are now LLCs because there is less paperwork involved as LLCs don’t have to abide by the same corporate laws as S corporations.
Major differences between LLCs and S corporations
- Limits on ownership. An S corporation is not allowed to have more than 75 shareholders. Each shareholder must be a U.S. citizen or resident. An LLC can have an unlimited number of members and they can be non-U.S. citizens and residents and other corporations or LLCs may be a member of a LLC.
- Allocation of profits and losses. In an S corporation, profits must be divided among shareholders based on the amount of stock each member owns. For example, a stockholder owning 10 percent of the corporation’s stock would get 10 percent of the corporation’s profits. The allocation structure of an LLC is a little more flexible, as members have more latitutde to divide profits as they see fit. For example, if an LLC has an active or managing owner, the other members who are silent partners or less active in the management of the company can chose to allocate a larger share of the profits to the more active member. This arrangement can be used to incentivize performance for members who may not have a large ownership stake in a company, but are instrumental to its performance.
- Corporation rules – S corporations are required to follow corporate rules including issuing stock, electing officers, holding regular board meetings, holding regular shareholders’ meetings and other corporation rules that may vary by state. LLCs are subject to fewer rules than corporations, and as long as members agree to the general direction of the business, corporate formalities such as board meetings and minutes are not required.
- One major S corporation shareholders have is that they are unable to take advantage of tax deductions for business debt. LLC owners can get tax breaks on business debt.
LLCs have become the preferred business structure for small businesses that want the tax advantages of a corporation, but that’s not to say that they don’t have drawbacks. Many states tack on franchise taxes or LLC fees to companies that are formed as LLCS, sapping some of the advantage of forming an LLC.
LLCs can also be costly to start, and many small businesses end up choosing the partnership business structure instead until they have the money or see the advantage of forming an LLC.
LLCs also may not issue stock options, a key advantage many corporations use to retain key employees.
Also, foreign countries may not extend the taxation advantages to LLCs that they receive in the U.S., choosing instead to treat them as corporations.
In most cases, an LLC will be the preferred option for small businesses seeking the advantages of incorporation, but in some cases, particularly in businesses where the owners may have a contentious relationship, the stricter rules of the corporation may be preferable to create a framework requiring the owners to work together harmoniously.
If you think you and your partners could benefit from a corporate bus