Many small business proprietors often select the incorrect business structure based on a misguided understanding of corporate structures. Below, we will break down the factors that will help you determine which entity structure might be best for your needs.

S Corporation

An S Corporation, or S-Corp for short, is a specific type of corporation that elects to pass its corporate income, deductions, credits, and losses through to its shareholders for federal tax purposes. Here’s a breakdown of key aspects:

Structure:

• An S-Corp is a legal structure that provides limited liability protection to its shareholders, just like a regular corporation (C-Corp).
• Unlike the C-Corp, an S-Corp has a special tax status with the IRS.

Management:

• S-Corps are managed by their shareholders, who elect a board of directors responsible for major decisions.
• Day-to-day operations are typically overseen by officers appointed by the said board of directors.

Taxation:

• The unique aspect of an S-Corp lies in its tax treatment. Unlike C-Corps, S-Corps avoid double taxation.
• Income, losses, deductions, and credits flow through to the individual shareholders’ personal tax returns (just like a regular partnership). The S-Corp itself does not pay federal income tax.
• Shareholders report their share of a S-Corp’s income on their personal tax returns, and they are taxed at their individual tax rates.

Requirements for S-Corp Election:

• To qualify for S-Corp status, a corporation must meet certain criteria, such as having 100 or fewer shareholders, having only eligible shareholders (individuals, certain trusts, and estates), and having only one class of stock.

Liability:

• Similar to other corporate structures, shareholders in an S-Corp enjoy limited liability, meaning their personal assets are generally protected from the business’s debts and liabilities.

Limited Liability Company

On the other side, the Limited Liability Company, or LLC for short, is a business structure that combines the limited liability protection of a corporation with the flexibility and simplicity of a partnership. Here’s an overview of what an LLC is and how it is taxed:

Limited Liability:

• The primary advantage of an LLC is that it provides limited liability protection to its owners, who are called members. This means that the personal assets of the members are generally protected from the business’s debts and liabilities.

Flexibility:

• LLCs are known for their flexibility in terms of management structure and profit distribution. Members can choose to manage the LLC themselves or appoint managers, and they can allocate profits and losses in a way that best suits their business agreement and not directly in line with the contributions made to the company.

Management:

• LLCs can be either member-managed, where all members participate in decision-making, or manager-managed, where members appoint managers (who may or may not be members) to handle day-to-day operations.

Taxation:

• One of the key features of LLCs is their “pass-through” taxation. This means that the LLC itself does not pay federal income tax. Instead, the profits, losses, deductions, and credits “pass through” the business and are reported on the personal tax returns of the individual members.
• The IRS default tax classification for an LLC with multiple members is a partnership. Each member’s share of the profits or losses is reported on their individual tax return, and they are taxed at their individual tax rates.
• Alternatively, an LLC can elect to be taxed as a corporation (either as a C-Corp or an S-Corp) by filing the appropriate forms with the IRS (not usually recommended). This election may be beneficial in certain situations, depending on the business’s financial structure and goals.

Single-Member LLCs:

• If an LLC has only one member, it is treated as a disregarded entity for tax purposes by default. This means that the income and expenses of the LLC are reported on the single member’s individual tax return.

Determining What is Right for You

The choice between an LLC and S-Corp revolves around the considerable flexibility of the LLC versus the tax benefits and financing advantages offered by the S-Corp.

Other considerations include the LLC’s adaptable management structure, which gives owners the flexibility to opt for either member or manager management. In contrast, S-Corps are subject to rigid regulations, including compulsory annual meetings and director obligations.

Do You Need the Flexibility of the LLC?

The flexibility of the LLC allows for profits and losses to be distributed unevenly among owners, catering to various scenarios where individuals take on distinct roles within the business. For instance, consider a tech startup where one partner contributes technical expertise, while another focuses on business development. The LLC’s flexibility allows them to tailor profit-sharing to match their respective contributions.

For sole proprietors, this flexibility extends to incorporating business income and losses into their personal tax returns, eliminating the hassle of a separate business filing. For example, a small budget freelance graphic designer who operates as a sole proprietorship would benefit from the simplified tax reporting.

The flexibility of an LLC also applies to management. The LLC’s operating agreement can outline responsibilities and decision-making authority with specific limitations to prevent the managers from stepping out of line. For example, in an LLC managing a creative design studio, the operating agreement could specify that one manager oversees client interactions, project planning, and creative direction, while another manages financial aspects, resource allocation, and operational efficiency. These defined responsibilities and decision-making authority, with outlined limitations, ensure that each manager stays within their designated scope, maintaining a balanced and well-organized management structure.

Compared to the LLC, the rigid structure of an S-Corp limits flexibility in management. The imposition of a board of directors can hinder the agency’s agility and responsiveness. Further, S-Corps are limited in who is allowed to be a Shareholder.

Most importantly, S-Corps strictly allocates profits based on ownership percentage. This restriction poses a significant drawback for businesses requiring adaptable profit-sharing structures to align with diverse contributions and arrangements.

Do You Prefer the Tax Savings and Structure of the S-Corp?

S-Corps still have their advantages. They can be more appealing to investors and banks, often seen as preferable entities for external funding. The familiarity of corporations contributes to their perceived stability. Additionally, S-Corps have a streamlined process for converting to a C-Corp, requiring only a form filing with the IRS, unlike the more intricate process for LLCs.

Further, and most importantly, S-Corps benefit from taxation. Unlike an LLC, shareholders can strategically plan salary and distribution payments to minimize self-employment taxes. Hence, whereas LLC members face self-employment taxes on their entire share of profits, S-Corp shareholders may avoid these taxes on distributions. Also included, S-Corp shareholders who work for the company can receive fringe benefits, such as health insurance and retirement plans, without these benefits being subject to income tax.

Additionally, studies suggest that S-Corps may have a lower audit risk compared to large partnerships like LLCs. S-Corps can also offer stock options and stock appreciation rights, providing valuable tools for employee incentives and retention.

Also, the uniform treatment for all shareholders may be an advantage to you. S-Corps adhere to the one-class-of-stock rule, meaning S-Corps strictly allocate profits and losses based on ownership percentage, ensuring fair and consistent treatment for all Shareholders. These rules provide stability to potential investors entering an unfamiliar business.

While these tax benefits and other considerations make S-Corps an attractive option, it’s essential to carefully consider other factors such as eligibility criteria, ownership limitations, and compliance requirements before making the decision.

Why Can’t I Just Use My LLC To Make The S-Election?

Now that you grasp the basics of entity structures and their management, a critical question arises: Can an LLC opt for S-Corp taxation while retaining the LLC advantages (like flexibility)? While tempting, this approach may get you in trouble. LLC operating agreements may inadvertently end the S-Election, necessitating language revisions. Moreover, key benefits of the LLC (such as uneven profit distributions) are taken away or diminished post S-Election. For these reasons, we rarely recommend pursuing the S-Election. Instead, we advocate for business owners to choose between forming an S-Corp or an LLC.

In conclusion, the decision between choosing an S-Corp or an LLC hinge on the specific needs and goals of your business. While LLCs offer flexibility, diverse tax options, and simpler conversion processes, S Corporations may appeal to those who seek savings on employment tax, outside funding or the traditional corporate structure. Consulting with an attorney is crucial to navigate the intricacies and make an informed decision aligned with your business’s long-term vision. Business Law Group is here to help you; reach out to us if you have any questions regarding starting your business. Give us a call at (719) 319-3744 or email us at info@businesslawgroup.us.