S Corp vs LLC
So, a couple of friends and you have finally decided to take your ideas to the next level and start a business partnership. Starting and running a business is all about making smart decisions and making them quickly. But the amount of decisions you face from the very beginning can be mind-boggling. Do you need to form a partnership like an LLC or a corporation like an S Corp? What are the tax implications? Do you need to convert to a different form of a business later? There is so much information out there describing the benefits and disadvantages of each form of business, and you may find yourself struggling to make any decision at all.
So, here is what we went through when we formed our company, EQUALLY SIMPLE, INC., and I will describe how we came to decide that S Corp is better for us instead of LLC.
In general, LLC is easier to form and maintain and it’s definitely more hassle free when it comes to filing documents and other corporate requirements. S Corp, on the other hand, requires more paperwork to set up and maintain the entity. While it provides some of the benefits of an LLC, S Corp is a much preferred form of a business if you are considering taking your business to the next level in the future. For example, if you need to get investments from VC firms, converting your business to a C Corp can be done in a single day if you are already an S Corp.
Let’s take a look at some of the pros and cons of LLC and S Corp:
LLC is a partnership and each stakeholder is called a ‘member.’ Forming an LLC differs slightly in each state, but instructions for New York State is well documented here. It is generally hassle free in most states, but New York State has this archaic law that requires all LLCs to publish their formation of LLC on at least two newspapers, which can cost you more than a few thousand dollars. And this can be a huge burden to many startups with a very limited budget.
- Limited Liability. As the name suggests, LLC provides protection from the company’s losses and liabilities.
- Pass-Through Taxation. This is probably the most important advantage of an LLC. LLC is not considered a ‘Corporate Entity’ by the government, per se, therefore there is no corporate level tax. This means everything, income and loss, can be passed through to its members, which get reported once at the end of the year in each member’s tax filing.
- Income and Loss Allocation Flexibility. With what’s called, an “Operating Agreement,” LLC allows its members to disproportionately allocate profit and loss among its members whereas S Corp’s profit and loss allocation is done strictly by the shareholders’ stock ownership. This flexibility can be handy when each member of the business puts in different amounts of work and there is a frequent change in its profit-sharing agreement among the members. But this could also add complexity to the ownership structure.
- Ownership Requirement Flexibility. One of the big advantages of an LLC is that it allows foreign partners to take part in the ownership whereas S Corp does not. LLC also allows an unlimited number of members whereas S Corp has a limit of 100 shareholders.
- Less paperwork and compliance requirements. LLCs are not required to have board of directors or hold annual meetings or file quarterly tax requirements. There is no need to file for a corporate level tax return, and all income and loss activity is reported on each member’s personal tax return.
- Self-employment Tax: One of the biggest disadvantages of an LLC is that most income is treated as self-employed income, therefore the owners are required to pay a 15.3% self-employment tax on income generated from the LLC as described in the IRS website. That 15.3% may mean a lot down the road.
- Outside investment: Due to lack of corporate structure and transparency, it is almost impossible to get an outside investment from VC funds as they prefer to deal with corporations (especially C Corporation). Conversion to C Corp from LLC is much more involved and complicated compared to S Corp conversion to C Corp. If you want to get funding from VC firms in the future, LLC may not be the choice of business structure.
- Limitations on nature of business: There is a limitation on the nature of business for an LLC. LLC can be formed for any kind of business as long as your business is not in banking, insurance, and certain other professional services, such as doctors, accounting, and real estate investments.
- Certificate of Publication Requirement: (New York State specific) New York State requires all LLCs to publish the formation of the LLC in at least two newspapers as stated in New York State, Department of State, Division of Corporations, State Records, & UCC. This upfront cost of up to $2000 can be a burden for a startup company.
- Transfer of ownership: LLC is treated as a partnership for Federal income tax purposes, so if 50% or more of the total interest in partnership capital and profits is sold/exchanged within a 12 month period, including a sale or exchange to another partner, then LLC will be terminated as indicated in the IRS website.
S Corporation (Inc)
S Corporation is a business entity that, like LLC, has a ‘pass through’ ability of income and loss to its shareholders for federal tax purposes, which allows its shareholders to avoid double taxation which would have otherwise occurred in C corporation. In general, S Corporation requires more paperwork and record keeping while allowing more transparency and clarity to the business and ownership structure.
- Limited Liability: Just like LLC, S Corp also gives you protection on your personal assets from corporate debts and liabilities.
- Pass-Through Taxation: As LLC does, S Corp allows its corporate level income, loss, deductions to be passed down to its shareholders, thus avoiding double taxation which would otherwise incur in C Corp. As a startup, where it incurs initial losses, this can be particularly beneficial.
- Lower Tax Rates for Income: As long as S Corp pays employees “reasonable” salaries along with associated payroll taxes, any remaining profits can be distributed to its shareholders as dividends, which are taxed at a lower rate than income, and shareholders don’t pay self employment tax that they are required to pay in LLC.
- Easy conversion to C Corp: Almost all VC funds require the business entities to be C Corp in order to receive any funding. S Corp to C Corp conversion can be done within a day with a simple unchecking of a box in a form. It makes it easy for a startup to receive tax benefits of an S Corp while it’s still at infancy and be able to convert itself quickly when it’s time for taking it to the next level for a round of outside investments.
- Ownership and Profit Sharing Clarity: Shareholder’s ownership of number of shares translates directly to how much the profit and loss of a company gets allocated to him/her.
- Easy Transfer of Ownership: Interests in an S corporation can be freely transferred without triggering adverse tax consequences. (In a partnership or an LLC, the transfer of more than a 50-percent interest can trigger the termination of the entity.) The S corporation does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred.
- Shareholder Eligibility Restrictions: Every shareholder must be a U.S. citizen or a permanent resident in order to take part in S Corp. If any of the founding members is a foreigner, S Corp may not be the right choice. Although it is rarely a problem, there is also a limit of a maximum 100 shareholders in S Corp.
- Ownership and Profit Sharing Inflexibility: This is something that could be considered part of the Pros but also part of Cons. While there is clarity of ownership and power with only one class of stock, this also means that profits and losses will be distributed to all shareholders in proportion to their ownership. You cannot have flexible profit distribution based on performance or other circumstances. If you want simplicity, this provides a clear way to distribute profits to its shareholders.
- Reasonable Salaries: It is required by law that all S Corp shareholders must be paid a reasonable salary even if the company may not be making money. This could be problematic for a young startup struggling with expenses without any profits.
- Corporate Maintenance: S Corp takes a bit more work to maintain as you are required to hold annual shareholder meetings, while keeping the records of any updates and changes from these meetings.
C Corp is the ultimate form of business you want to convert your business into, regardless of whether you have an LLC or an S Corp. If you want to expand your business and involve outside investors and receive VC fundings, or take the company public through an initial public offering (IPO), you need to be a C Corp.
Then why not just start as a C Corp? You can – but there are some disadvantages to being a C Corp, especially if your startup is at infancy and does not generate much profit. It will incur more up front cost compared to the other two forms of business that we covered previously. In a C Corp, any profits are taxed automatically at the corporate level when they are earned, and they are taxed again at the shareholder level when they are distributed as dividends. This is often referred to as “double taxation”. Another disadvantage is that corporate losses cannot be deducted by the shareholders. This is one of many reasons startups often start their business as an S Corp, as it is likely to have initial losses, and later convert to a C Corp, when the business becomes stable and need outside investment.
So, why did we choose S Corporation ?
We knew both LLC and S Corp provide personal protection against corporate liabilities, but as a young startup, initial upfront cost was the most important factor to consider. We knew there may be some initial losses, and we wanted to get the maximum tax benefits by being able to deduct the losses in our personal tax filing, while also avoiding paying self employment taxes on any profits which we would incur in an LLC. Moreover, in New York, LLCs are required to publish the forming of LLC in two newspapers which could bring up our initial cost by a few thousand dollars. We thought it would be better for us to invest that money into our own product development instead of trying to conform to some archaic state law that does not benefit our company in any way.
S Corp also provides absolute clarity and simplicity to the ownership structure as well as profit-sharing structure. There is only one class of stock in S Corp and each shareholder’s percentage ownership of the company translates directly into the proportional distribution of profits. As all entrepreneurs do, we also thought about the future potential of the company. As S Corp to C Corp conversion is almost instant, it made most sense for us to choose an S Corp over an LLC for our startup venture.
You may also like our 6 Tips on Starting Your Own Part-Time Business and 7 Business Lessons from CNBC’s “The Profit” by Marcus Lemonis.
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