Why it Matters when Choosing LLC versus S-Corp Status
Recently, I have noticed that nearly all newly formed entities for new businesses are choosing to become a LLC (limited liability company) as opposed to an S-corporation. There does not seem to be a reason for this. The legal professions could be pushing this form of entity.
A Limited Liability Company (LLC) is a business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation.Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs, those having only one owner.
S corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid “double taxation” on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income.To qualify for S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders
- including individuals, certain trust, and estates and
- may not include partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have one class of stock
- Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.
It is important to understand, the S corporation entity has been around for many more years than the LLC. The case law surrounding this form of entity is well defined. When you are the owner of a LLC unit, what do you own? Stock? I don’t think so! You own whatever the member control agreement say you own. Can your ownership be taken away? Yup. If the member control agreement says so. I have heard recently that a owner of an LLC could be removed as a member of the group ‘for cause’. I.e. nonperformance of his/ her duties.
If you own stock in a corporation, you own the stock and all of the rights associated with the ownership of an entity’s stock by law, not a member control agreement.
Another thing to consider is, a LLC is presumed to be a partnership and taxed as such. Which means that all of the earning are ‘personal service income’. Those types of earnings are subject to Social Security and Medicare taxes. (You could elect with the IRS to be an LLC ‘taxed’ as an S corporation and avoid the unintended consequences of the personal service income trap, but why not just go with the S corporation in the first place?)
Navigating the waters of correctly setting up or changing a legal and taxable entity is confusing. For advice from experts who will listen to your individual situation and make the best decision, turn to the experts at Foreman and Airhart. We’d love to get to know you and make sure you start off on the right foot.