What Legal Structure is Best for Your Small Business: LLC vs. S Corp?

What is an LLC and S Corp?

A limited liability company, or LLC, is a business structure that is taxed like a partnership or sole proprietorship. Taxes are reported on the owner’s personal tax returns. Additionally, business liabilities belong to the business and not to the owner. 

An S corporation, or S corp, is a business tax filing status that allows corporations to pass corporate revenue such as income, losses, deductions, and credits through to shareholders, but only if certain requirements are met. 

A business can have an LLC structure and choose to be taxed as an S corp, but it must meet specific IRS guidelines to qualify as an S corporation. 

What are the Similarities Between LLCs and S Corps?

Despite an LLC being a business structure and S corp being a tax status, there are many similarities between the two, such as:

• Limited liability protection: Owners of LLCs and S corporations do not personally have responsibility for business debts and liabilities. The LLC or S corporation serves as the business’s owner and is responsible for debts and liabilities.
• Separate entities: LLCs and corporations are viewed as separate legal entities created by state filings. However, the two are formed under and governed by very different state business entity statutes.
• Pass-through taxation: LLCs and S corporations are both considered pass-through tax entities. Pass-through taxation indicates that no income taxes are paid at the business level, and profits or losses are passed through to the owner’s tax returns. All necessary tax is reported and paid at the individual level. 
• Ongoing state compliance requirements: Both LLCs and S corporations are subject to certain obligations from the state corporation and LLC statutes, such as appointing and maintaining a registered agent, filing annual reports, and paying annual fees. Additionally, both must notify the state of certain changes, including change of name, registered agent or entity type, and qualifying for business in states outside of the formation state. 

What are the Most Important Differences Between LLCs and S Corps?

Several key differences between the two pertain to ownership, management, and ongoing formalities that will be discussed in greater detail below:

Ownership

The IRS restricts S corporation ownership but not LLC ownership. Restrictions include:

• LLCs are allowed unlimited members, while S corporations may not have more than 100 shareholders or owners.
• Non-citizens or residents may be members of LLCs, while S corporations are not allowed non-citizens or residents as shareholders.
• S corporations cannot be owned by corporations, LLCs, partnerships, or many trusts, while LLCs can.
• LLCs may have subsidiaries without restriction.
• S corporations may not issue classes of stock with different financial rights, such as granting some shareholders a preference for distributions over other shareholders. LLCs do not have these restrictions.

An S corporation may own an LLC, but an LLC is generally not allowed to own an S corporation unless the LLC:

• Is a single-member LLC that is used as a disregarded entity for federal tax purposes, and
• Meets eligibility requirements to be an S corporation shareholder

Management

LLC owners can choose to have members or managers operate the LLC. When members manage an LLC, the business operates like a partnership. If there is only one member, then this is regarded similarly to a sole proprietorship. For businesses run by many managers, the LLC is considered more closely related to a corporation because members will not be involved in the daily business decisions.

S corporations have directors, officers, and a board of directors to oversee corporate affairs and handle major decisions but not daily operations. Instead, it is the directors’ responsibility to elect officers who will manage daily business affairs. Shareholders have no rights to manage the business and affairs.

Ongoing formalities

Corporation laws have more requirements regarding management structure than LLCs, and LLCs face more extensive internal formalities. While it is not a requirement for LLCs to follow these internal formalities, they should do so. 

• The requirements for S corporations include adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings, and maintaining the minutes of meetings with corporate records.
• Suggested formalities for LLCs include constructing an operating agreement, issuing membership shares, holding and documenting annual member meetings, and thoroughly documenting all major business decisions.

Is an LLC or S Corporation Right for Your Business?

A business owner may prefer an LLC if:

• A high degree of management flexibility is needed to run the company.
• Profits and losses are allocated based on criteria other than ownership percentage.
• State-mandated requirements, such as annual meetings, should be avoided.
• Raising capital through the sale of ownership stakes to many investors or by going public is not an option.
• Pass-through taxation is important.

A business owner may prefer an S corporation if: 

• Earnings distributed proportionately to capital contributions are preferred.
• A salary is more desirable than self-employment income.
• Easily obtaining investment capital is necessary.
• Pass-through taxation is preferred but with the corporate form of entity.
• Eventually, becoming a C corporation is a goal.

Do You Need an Attorney?

If you are about to venture into the business market and have questions regarding the right structure and tax status for your company, you deserve an experienced attorney who has the knowledge and experience in this legal landscape to help you make the best decision for you. Call Fisher Stone, P.C., today or fill out a contact form to schedule your free consultation.

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