Welcome to the FAQ article. In these weekly blogs, I attempt to expand on a particular question I field throughout the week. This allows me to both dive deeper into the inquiry that I generally am unable to do in the constraints of a phone call and provide my audience with solutions and answers to themes I know are prevalent, misunderstood, and sometimes dangerously ill-applied.
“Hey Chris, I’m ______ (starting a business, currently a sole proprietor, or partnership) and was wondering if I should become an S Corp or LLC?”
This is an important decision for California business owners, and often the decision is narrowed down to the California S Corporation or the California Limited Liability Company (LLC) due to their basic benefits of liability protection and pass-through taxation. It is important to understand that the S corporation designation is merely a tax choice made to have your business taxed according to Subchapter S, hence the designation of Chapter 1 of the Internal Revenue Service Code. All S corporations begin as some other business entity, either a sole proprietorship, a C corporation or an LLC. The business then elects to become an S corporation for tax purposes.
Both LLCs and S corporations surged to the forefront around the time of the Small Business Protection Act of 1996 that contained a number of changes to basic corporation tax law, such as enabling S corporations to own any percentage of stock in C Corporations (C Corps cannot own stock in S Corps). Currently, with the Senate preparing to vote on the 2017 Tax Cuts and Jobs, this will provide additional changes that will need to be considered.
As a general rule, it is usually more productive to narrow the focus on (3) key areas that will be an important consideration to you as a business owner.
- Limiting taxes associated with the business
- Limited potential personal liability from the liabilities of the business, along with formalities necessary for such limited liability.
- Special circumstances particular to ownership and importance to principals
So, if you’re starting a business, it is important to know prior to working with an attorney on creating an entity how many owners this new entity will have and which of the above considerations are most important to each owner. This is critical if you have varying goals of the owners that require minimal compromises. Though there are some clear similarities, it is important to highlight the differences:
Differences in ownership and formalities
The IRS restricts S corporation ownership, but not that of limited liability companies. LLCs can have an unlimited number of members; S corps can have no more than 100 shareholders (owners). Non-U.S. citizens/residents can be members of LLCs; S corps may not have non-U.S. citizens/residents as shareholders. This is important with real estate investors looking to expand their pool of investors beyond US borders. S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships or many trusts. This is not the case for LLCs. Lastly, LLCs are allowed to have subsidiaries without restriction.
S corporations face more extensive internal formalities. LLCs are recommended, but not required, to follow internal formalities. Required formalities for S corporations include: adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings, and keeping meeting minutes with corporate records. Failure to respect the corporate formalities could lead to the piercing of the corporate veil. Those who go the S-corp route should consider working with an attorney that provides annual compliance services. I’ve seen too many instances of minimal cost self-help or online solutions that do not follow through on the other documents or formalities after providing stamped articles of incorporation. It is often recommended that LLCs include some of the formalities by issuing membership shares, holding and documenting annual member meetings (have a board of advisors meeting during Thanksgiving and expense the dinner!), and documenting all major company decisions.
California LLCs are required to have an operating agreement. This agreement can be oral or written. In fact, with an LLC operating agreement, you can essentially create the management structure of your choosing. If it’s written, the agreements—and all amendments to it—must be kept with the company’s records. If you do not create an LLC operating agreement, you will be subject to your state’s default LLC rules. These are one-size-fits-all rules; they are not tailored to the wants and needs of your business. LLCs, especially, one-person LLCs, are given much more respect by courts if they’ve created an LLC operating agreement. Again, avoid using the LLC company kits that only file the articles of organization, leave unissued membership certificates sitting in the back of the corporate book, have no statement of information filed, and have an inadequate boilerplate operating agreement (often unsigned and untouched). The situation is compounded further when several years after formation, a disagreement amongst owners arises about distributions and/or allocations, and the key business terms (that should have been addressed in a well drafted operating agreement) are inserted or buried in roughly outlined emails.
A great advantage of having an LLC is choosing how you’ll split profits, work-load, distribution of shares and more. In more rigid structures like S corps or C corps, you have less flexibility to choose the roles and rights of each business owner. For example, in a C corp, if you’ve invested 30% of the capital in the company, you’re likely to receive 30% of the profits or losses. An LLC allows you to set this up differently. For example, say that our hypothetical 30% owner actually does 70% of the work, whereas her partner invested 70% but does only 30% of the work. In their operating agreement, these partners could choose to split the profits and losses 50%.
Differences in management
Owners of an LLC can choose to have members (owners) or managers manage the LLC. When members manage an LLC, the LLC is much like a partnership. If run by managers, the LLC more closely resembles a corporation; members will not be involved in the daily business decisions. S corps have directors and officers. The board of directors oversees corporate affairs and handles major decisions but not daily operations. Instead, directors elect officers who manage daily business affairs.
Other important differences
It is also important to note that similar to an LLC, the S corp must pay an $800 California state franchise tax for the privilege of doing business in California. However, one big advantage of the S corporation is that it avoids the gross receipts tax of the LLC, in which gross receipts of an LLC over $250,000 are taxed. This additional “gross receipts” tax can be anymore from $900 for annual gross receipts less than $500,000 to as much as $11,790 for annual gross receipts greater than $5 million.
An S corporation’s existence is perpetual, but some states require LLCs to list a dissolution date in the formation documents. Certain events, such as death or withdrawal of a member, can cause the LLC to dissolve. Similar to the S corporation, transferability of a membership interest can be accomplished easily so long as it is not precluded in the operating agreement or in some other legal document such as a membership interest buy/sell agreement. Before the transfer of any LLC membership interest, one should always consult the provisions of the LLC operating agreement to check for any transfer restrictions or integrated buy/sell provisions. S corporations may have preferable self-employment taxes compared to the LLC because the owner can be treated as an employee and paid a reasonable salary. FICA taxes are withheld and paid on that amount. Corporate earnings after payment of the salary may be able to be treated as unearned income that is not subject to self-employment taxes. These self-employment tax savings can more than offset any extra expenses associated with stricter corporate formalities.
LLCs are easier and less expensive to set up and simpler to maintain and remain compliant with the applicable business laws since there are less stringent operational regulations and reporting requirements. Nonetheless, the S corporation format is preferable if the business is seeking substantial outside financing or if it will eventually issue common stock. It is, of course, possible to change the structure of a business if the nature of the business changes so as to require it, but doing so often involves incurring a tax penalty of one kind or another. Therefore, it is best if the business owner can determine the most appropriate business entity choice when first establishing the business.
*Author’s Note – This just got a little bit more complicated with the pending 2017 Tax Cut and Job Act. If the law passes, it is critical that you run cost-benefit analysis (Use 10 years and factor in an entity exit/termination) between S-Corp and C-Corp.
This article contains general legal and tax information and does not contain legal and tax advice. Lionshare Partners is not a law or tax firm or a substitute for a tax attorney or law firm. The law is complex and changes often. For legal or tax advice, please ask a tax lawyer.