S-Corporation or LLC? That Is the Question
Posted: Thursday, February 04, 2010
by Nina Kaufman
Ask The Business Lawyer
How do business owners protect their personal assets when things go wrong with the company? This question has worried many an entrepreneur. Until they figure this out, it must be hard for business owners to focus on running their businesses. This is especially so if they're concerned about possible lawsuits.
One of the simplest ways to protect yourself is to form a separate business entity. That way, the entity (not you, personally) takes the "hit" from any lawsuit that might occur in the course of your business. That's also why they are called "limited liability entities," because they limit your personal liability. Limited liability entities come in many forms including the C-corporation, S-corporation, limited liability company, limited partnership, professional corporation (or, in some states, professional association), limited liability partnership, and professional limited liability company. Like the dessert tray at a buffet, all will meet a particular need, but are slightly different in their form and composition, and some aren't right for everyone.
1. Who are the business owners? How many of them are there? Are they foreign investors who live overseas, even if they are family or relatives? Are you running the business alone? Are you practicing a profession? Your answers to these questions will shape the business structure that is optimal for you. For example, an S-Corp cannot have more than 100 shareholders, all of whom must be US residents and citizens. A LLC has more flexibility, other than needing a minimum of two owners in some states. Further, some states require that the owners of professional corporations be licensed practitioners of that particular profession, e.g. only licensed contractors can own a contracting company.
2. How much flexibility do you require in distributing profits? If there are two parties, each investing different amounts of money, but with one pouring in sweat equity, how do you plan to divide profits and management control? In such a case, a limited liability company is the better business structure -- it affords flexibility in dividing profits which does not have to directly link to how management control or ownership is divided. For example, if there are two of you, you can set up an LLC in such a way that you can control 60% of the company for the sweat equity you are investing, but are apportioned only 30% of the profits. The other shareholder, as the major financial investor, could receive the remaining 70%. In an S-Corp, there is only permitted class of shareholders, and share of profits are directly linked to the percentage of ownership. This will not work for business owners who need some flexibility in divvying up profit and management control.
3. What will you pay in taxes? Both S-Corps and LLCs provide certain "pass-though" tax advantages to small business owners. This means that the profit or loss generated by your business gets reflected on your personal income tax return instead of being first taxed to the company and then again to you when you receive your distribution (hence, the dreaded "double taxation" of C-Corps). LLCs are generally taxed like partnerships, which means a complete pass-through to your personal tax return. However, some states do not allow a complete pass-through for S-Corps - so even though your company may not pay federal tax, it may still be subject to state taxes. There are also local taxes that you may need to factor in as well. To get a sense of what your tax bite might be, ask your accountant to run the numbers based on your projected income and expenses. The difference could be significant.
4. How much does it cost to form and maintain the businesses structure? Costs of formation vary, depending on the state in which you live. In some states, like New York, the costs of forming an LLC far exceed that of an S-Corp. However, these initial costs need to be weighed against the ongoing accounting costs of corporate tax returns (which may be higher than the returns for an LLC), and the legal costs of keeping up with corporate formalities like meeting minutes. LLCs do not generally have the same documentation requirements (although it's a good idea and good practice to do so anyway).
Do your due diligence at the start to pick the business structure for you and your shareholders. It is too difficult and costly to change it later. For more advice, consult with an attorney and an accountant who can best explain the various organization types and find the best match for you.
Copyright (c) 2010 Ask The Business Lawyer
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