Since the state of Wyoming first introduced and used the Limited Liability Company as a form of business entity, the decision to create a startup business as an LLC or S Corp has required more thought. Each have their own advantages for new business owners depending on where that business is registered, the type of product or service being provided, who’s running the business, and how ownership is distributed.
The business registration aspect is simple enough, just follow the guidelines and procedures laid out by your individual state or federal government. It’s weighing the pros and cons that make the decision a little harder for some. Both entities help you avoid paying personal and corporate taxes. This is a great thing for any business owner and not to be confused with tax evasion which is very illegal. Tax avoidance means you’re taking legal measures to minimize your future tax expenses to the IRS while tax evasion means you’re not paying taxes you already owe to the IRS. Let’s simplify the advantages and disadvantages of the LLC and the S Corporation.
The Upside of Forming an LLC
It’s simply cheaper to setup: On average, you’ll pay less than two hundred dollars in most states to form an LLC.
Your personal assets are legally protected from your business creditors. SO they can’t come after you for more than the amount you own in the company.
If you’re a small brick and mortar (traditional type) business or do business solely on the internet, an LLC might be your best choice for a corporate entity. There’s less paperwork to set it up which makes filing and reporting yearly business activities much faster and easier. Also most new business owners generally operate the business by themselves or with a partner. An LLC would not require them to elect officers or hold legally required meetings like an S corp does.
Due to the simplicity of forming an LLC, you can rest more easily knowing you’ll spend much less paying an accountant or lawyer to handle paperwork or avoid it all together if you have the knowledge to do it by yourself.
You’ll avoid filing separate annual state and federal tax returns for an LLC because you include that information in your personal yearly tax return.
Huge bonus for LLC owners with significant cash flow (business profits)
If you expect to have a successful cash generating business, you can form as an LLC but choose to be taxed as an S Corp. Limited Liability companies that make a lot of money relative to their business size are subject to higher business taxes, but the legal structure of an LLC allows it’s owner to file lower taxes under an S Corp status. The excess profits from the LLC can be given out as dividends to the business owner(s) after reasonably allowed salaries have been paid. It’s legally advisable to pay yourself even a small amount if you pay yourself and others dividends. You can’t pay yourself entirely in dividends.
The Downside of forming an LLC
As the name implies you are financially liable for whatever percent ownership you hold in the company. The more you own, the more you’re liable for and vice versa.
You’re subject to quarterly self-employment Tax payments if you’re the only owner in the company.
The LLC must remain an independent active entity in the eyes of the IRS. You can’t manage business affairs of the LLC as your personal business. Unlike a sole proprietorship where the business and the owner are the same, an LLC must be mostly separted from it’s owner and show a business operating profit or loss. The owner also cannot legally use profits from the business for personal expenses. You can only do so from your own salary only if the LLC generates enough profit to create salaries.
The Upside of Forming an S Corp
A business with a clear potential for fast growth, which plan to finance business operations by investor capital, and distribute company shares to employees is better off filing as an S Corporation to maximize tax benefits. If you plan to include investors as financers or advisers, switching your LLC to an S Corp is highly recommended.
The paperwork involved to setup an S Corp is more detailed and labor intensive but the benefits far outweigh the clerical work. Elected officers and investors are immune from potential financial liabilities in an S Corp. This is a major selling point to banks and investment firms who want to invest start-up capital in new companies.
Other Benefits of an S Corp:
Like an LLC, your personal assets are protected from your business creditors. They can only go after the business itself, not the owners assets.
The legal structure of an S Corp allows salaried owners to pay themselves or their employees dividends if the company exceeds normal profit expectations. This tax benefit is referred to as distributions.
Many pre-tax expenses are tax deductible. Popular deductions for smaller business owners include office supplies and equipments, travel expenses, health care expenses, business related utilities, and communication services.
The Downside of Forming an S Corp
The additional paperwork and expenses to form an S Corp results in a much higher setup cost compared to an LLC. Also you can’t even form an S Corp unless you meet the following qualifications:
Only United States citizens and permanent residents can form an S Corporation which are limited to 100 or less persons who can hold interest in the company (shareholders).
You risk paying additional business taxes on the state level, especially if you’re not registered in a pro-business state.
Every shareholder must share the profits or losses in the company according to their company percent ownership. If company financial losses are great each shareholder share a bigger loss, and if company financial gains are great each shareholder share a bigger gain.
The corporation is limited to a single class of common stock. So you can’t have both class A and class B shares of stock. It has to be one or the other.
All persons with ownership in the S Corp are legally required to follow the rules for governing an S Corp. If not, the company can lose it’s S Corp status to become a less desirable C corporation.