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Briefly measuring the pros and cons of business entities: LLC or S-Corp
Two of the most common business entities for small companies are the limited liability corporation and the S-Corp, but how do you know which entity is appropriate for your business?

Two of the most common business entities for small companies are the limited liability corporation and the S-Corp, but how do you know which entity is appropriate for your business? The answer may come down to cost, attraction of capital as your business grows, and tax considerations, among others.

To begin, the major advantage of filing either as an LLC or S-Corp is that both entities offer limited liability, which means the personal assets of the business owner are protected from the creditors of the business. Therefore the owner is only financially responsible for the amount invested in the company and no more. However, a business owner can be personally responsible for the business if a bank requires a personal guarantee for a loan or if the business owner ignores the entity and uses the assets of the business for personal use. In addition, both types of business entities help owners avoid paying personal and corporate taxes. For tax purposes, an LLC is referred to as a "pass-through" entity, which means all income and expenses of the business are usually reported on the LLC owner's personal income tax return. In an S-Corp the owner may choose to be taxed at the entity or individual level. The flexibility can be beneficial depending on the growth and size of the business.

Pros and Cons of LLCs and S-Corps

The owner of an LLCcan benefit from its ease and inexpensive cost to setup but must report self-employment taxes. The pros of an LLC include but are not limited to the following:

1. The owner of an LLC does not have to file a tax return for the LLC since the information is reflected on the owner's personal tax return.

2. An LLC is easy to organizationally to setup, especially if the LLC is a single-member LLC.

3. Inexpensive to start: The cost of setting up an LLC is low, including filing fees.

The cons of an LLC include but are not limited to:

  • Self-employment tax: Single owners of an LLC are required to pay self-employment tax on income generated by the LLC. This means single owners must make quarterly estimated payments to the IRS.
  • Owners of an LLC must respect the legal status of the entity, meaning the owner has to operate the LLC separate from his or her personal affairs.

In comparison to an LLC, an S-Corp offers a tax advantage when it comes to distributions but has stricter requirements to form and maintain.

The central benefit of an S-Corpwhen compared to an LLC is that an owner has the chance to receive distributions, which are taxed at a lower rate than income. The S-Corp pays its employees, including its owners, a reasonable salary often based on industry norms and any remaining profits the company holds can be distributed to the owners as dividends. Dividends are taxed at a lower rate than income thereby saving owners some money in reduced taxes.

S-Corps have stricter guidelines than LLCs, which can be a con for some owners. According to the federal tax code, to create an S-Corp an owner must be a U.S. citizen or resident, the entity cannot have more than 100 shareholders, the corporation must only have one class of stock, and profits and losses must be distributed to shareholders in proportion to the shareholders interest. The other cons include:

  • It costs more to form an S-Corp.
  • Shareholders must adhere to the formation requirements at all times otherwise the S-Corp is disallowed and the S-Corp will be treated as a C-Corp.
  • S-Corps have passive income limitation, which means the entity cannot have more than 25 percent of gross receipts from passive activities like real estate investment.
  • An S-Corp may be subject to additional state taxes.
  • Shareholders of an S-Corp should be sure to pay themselves a "reasonable" salary for the work they complete for the entity because the IRS is giving increased scrutiny to S-Corps for that reason.

The incentives and reasons to choose an LLC or an S-Corp or another legal entity are varied and complicated. Before you form your business, it's important to sit down with an experienced business law attorney who can advise you on the entity that will best fit your business at formation and beyond.

Keywords: business formation
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