Comparing Limited Liability Company and S-Corp

Comparing the benefits and burdens of Limited Liability Company (LLC) and S-Corp is important, they are not the same. Before you blindly jump into one or the other you should know what you’re getting and what you’re giving up.  This post will introduce some of the important considerations in entity selection.

Available Alternatives.

There are a number of forms of business entity available under state law – sole proprietorships, partnerships, corporations and LLCs.  Federal law applies different tax code provisions to the different state law entities.  Federal law also allows LLCs to elect different tax treatment under federal law.  There are businesses today that operate in each of these different forms.  Most small businesses are formed either as sole proprietorships, limited liability companies or S Corps.

Sole proprietorships are popular simply because it is the default entity if nothing more formal is done.  No formalities are required for its creation.  The primary disadvantages of this form are that you can only have one owner and he is personally liable for all debts and losses.  If the business encounters financial difficulties or customers or others are harmed by the activities of the business, the owner’s personal assets and business assets may go to the creditors.

Partnerships and limited partnerships must have two or more owners.  But all the owners in a partnership or the general partner in the limited partnership will have unlimited liability.

LLCs and corporations avoid the disadvantages of sole proprietorships and partnerships.  You can form one with one or more owner.  They have limited liability for entity conduct.  You may still face personal liability; but, it will be limited to actions that you take.

LLCs and S corporat5ions also share the same tax attributes of a sole proprietorship.  Your income and losses will be reported on your tax return due to pass-through treatment for income tax purposes.  Pass through treatment is desirable for startup businesses because they tend to have losses in the beginning.  You can offset those losses against other income.

Differences between Limited Liability Company and S.

Although LLCs and S-Corps share common attributes there are important differences.  These differences may make one form of entity better than the other depending on the circumstances.

Advantages of the Limited Liability Company

Although LLCs and S-Corps both offer pass through treatment, LLCs are more transparent than an S corp.  For example, property can generally be transferred tax free by a member to an LLC or from the LLC by a member.  In contrast S Corps only allow members to transfer tax free to the entity at formation.  Subsequent transfers may result in gain unless you then own 80% of the entity.  The withdrawal of property from the entity is generally a taxable event that is recognized by the S-corp regarless of ownership percentage.

Since an S corporation may be required to recognize gain on the distribution of property to its shareholders and S corp is not a good form of entity that owns real property or other assets that are likely to appreciate.  Once the property is transferred to an S corp it may be impossible to get it back out without tax cost.  This limits the flexibility to change the form of ownership of business assets.

The amount of losses that an entity has flows through to the owners; but, the losses that may be claimed are limited to their basis.  In an LLC the members get to include the LLC’s debt as part of their basis even if they are not personally liable.  In contrast the S corp shareholders do not get to include the debt as part of their basis.  Accordingly, if early year losses are likely the LLC gives you the best bang for the buck.

Sometimes different owners have different cash needs or tax allocations.  For example the capital partner may find losses useful while the working member needs an income to live.  The LLC can allocate early year losses to the capital partner and away from the working member.  In constrast the S corp cannot make special allocations.  All allocations must be in proportion to their stock ownership.

LLCs have no limit on the number or character of their members.  In contrast the S corp cannot have more than 75 shareholders, they must all be US citizens or residents, they cannot have corporate or LLC shareholders.  This can severely limit the S-corp existence if members begin dieing.

C-Corporations that qualify as small business corporations may qualify for a 50% exemption from gain tax if the shares are held for five years.  Entities that start as an S-corporation do not qualify.  S-corporations that convert to C-corp status may qualify.

S-Corporations must be managed like a regular corporation, including the formalities of annual shareholder and boar member meetings.  Elections of officers, financial statement reviews and delefation of authority.  In constrast LLCs can operate is a wider range of conduct.  They can designate a single manager that makes decisions, a management group or member managed entity.

Both state and federal laws prohibit offering or selling securities without registration.  Certain types of transactions are exempted from the registration requirement, which allows many small businesses to sell stock or membership interests without complying with the burdensome registration requirements.  LLC interests in LLCs that are member managed may not be classified as securities and not subject to the registration requirements.

Advantages of the S Corporation.

Although LLCs have a number of advantages, S corporations have one very important advantage that alone causes many to select this form of business.  A portion of the income from an S corp may escape employment taxes whereas all of the income from an LLC is often subject to this tax.

If the members of the LLC participate in management all of the income is treated as self employment income.  This means the members will have to pay self-employment tax on a current basis on all income of the LLC, including income retained by the LLC to provide working capital or to acquire capital assets.

S corps can use cash accounting in circumstances that an LLC is required to use accrual based accounting.

S-corps have lots of decisional law that provides clarity and certainty in court decision making.  The LLC statutes across the nation are far more varied, there are fewer decisions to rely on and are more open to potential conflict.

As you can see the different entities have different benefits.  To confirm whether an LLC is the best entity for you I need to know more about the intended business venture.  We need to consider management structure, if any, and details about your exit strategy

  1. What is the name that you want to have?
  2. What will be the address for the office?
  3. You may select Alaska Law Offices, Inc. as your registered agent.  If you have another name or entity, we will need that.
  4. Will you be the only member or will their be other members.

If you will be the only member you can operate the entity without an operating agreement.  However, you will need to draft and adopt an operating agreement before you allow any other members into the entity.  The operating agreement controls the relationship of the members to each other and to the entity.

For help understanding your entity selection process, give us a call at 907-375-9226.

Clayton Walker, JD

Alaska Law Offices, Inc.

240 E. Tudor Rd. Ste. 230

Anchorage, AK 99503