Choice of Entity: S Corporation or LLC?
When the time comes for a business to adopt a formal entity structure, several important issues must be considered. It is difficult to determine which entity is the better choice without understanding the overall objectives of the business and its owners or investors.
Historically, the entity of choice for business start-ups was the S Corporation. However, formation of a limited liability company (or LLC) provides a viable (and sometimes better) alternative for many business and investment situations. Selecting the best entity for a particular type of business or activity will depend upon a number of factors, including the type of business or investment activity, its anticipated growth, and the long-terms objectives of the owners and participants.
S corporations and LLCs are popular entities in which to operate a business as both provide pass-through tax treatment and limitation of owner liability. Shareholders in an S corporation, and members of an LLC, will report the income of the entity on their individual income tax returns. In addition, formation of either entity requires filing with the Secretary of State’s Office, and for LLCs with more than one member, filing with the Internal Revenue Service. Each type of entity also provides distinct alternatives as to structure, management, and many other facets of business operation.
S corporations provide an advantage when considering employment taxes. All income of an LLC is subject to self-employment tax if it is allocated to a member involved in the management of the activity, whereas income from an S corporation is subject to employment tax only if distributed to the shareholders as compensation.
Self-employment tax is imposed at the rate of 15.3% on the first $80,400 of an individual’s income from self-employment, and is imposed at the rate of 2.9% of self-employment income in excess of $80,400. A business operation that becomes profitable in its operations may realize substantial tax savings if organized as an S corporation rather than as an LLC, if the corporation retains its earnings in order to fund future growth.
Formation of an LLC offers advantages in other areas. For example, the Internal Revenue Code limits the number of shareholders of an S corporation, and does not permit corporations, partnerships or LLCs to own stock in an S corporation. There are no such limitations on the type and number of persons or entities that may be members of an LLC, providing a broader field of potential investors for a start-up venture.
Formation of an LLC also provides flexibility in management as well as allocation of earnings among members. In an S corporation, all income, losses, tax items and distributions must be allocated between shareholders according to their stock ownership. An LLC may allocate these items based upon the economic arrangement of the members, not necessarily in accordance with the capital contribution of each member.
Real property ownership by an LLC provides added beneficial tax treatment, as a contribution to the LLC by the member is tax-free and withdrawal from the LLC by a member is tax-free. In the case of an S corporation, property transferred to the corporation at its organization is tax-free, but later transfers may result in recognition of gain unless made by a shareholder owning at least 80% of the stock. In many instances, withdrawal of the property from the corporation by a shareholder will generally be a taxable event.
It is evident that use of an LLC may provide certain advantages, and use of an S corporation may provide other advantages. Of course there are other significant differences between these two entities, but they are beyond the scope of this article. The form of business entity that is appropriate for a particular business or venture depends upon the advantages that are most important to the owners or participants. This article highlights only a few of the factors that must be considered in choosing the proper entity for a particular activity. It is important to remember that when determining which type of entity is the best choice, consideration must be given to the particular facts of the situation. We regularly assist clients by analyzing and explaining the issues, and then making sure the entity selected is properly formed to retain the expected results.
Please feel free to call us if we can help you with this important step in the life of your business.