Should your business be an S-corp or an LLC?

By Jerry Meek

If you’ve decided not to establish a C-corporation, chances are you are considering either an S-corporation or a Limited Liability Company (or LLC) as the alternative.  Technically, S-corporation status is a federal tax status, while an LLC is a type of legal entity created under state corporate law.  But, as a practical matter, LLCs almost always stick with the default tax rules, under which they are treated either as a sole proprietorship or a partnership, depending upon the number of owners.  (In the discussion that follows, I assume that these default rules apply.)

In addition to the advantages of limited liability, both S-corporations and LLCs offer the benefits of pass-through taxation.  In other words, unlike the C-corporation, no tax is paid by the entity itself.  All of the business income passes through to the owners of the business, who report it on their own tax returns.

Although similar, there are important differences between the S-corporation and the LLC that ought to be considered when deciding which path to take.  Here are a few of the larger questions to ask.

How will the business be financed?

With both an S-corporation and an LLC, business losses flow-through to the owners and potentially can be used to offset the owners’ other income.  But there are limitations, the most significant of which is the rule that an owner cannot deduct a loss in excess of “basis.”  A complicated calculation, basis is intended to reflect the owner’s capital investment in the business.  With both an S-corporation and an LLC, basis is adjusted upward whenever the owner makes a loan directly to the business.  But, if the owner only guarantees a loan from a third-party instead of making a direct loan, there is an upward adjustment to basis for an LLC but not for an S-corporation.  As a result, if a significant source of financing will be third-party loans guaranteed by the owner(s), this favors the creation of an LLC.

In addition, an S-corporation is only allowed to issue one class of common stock.  While there can be both voting and non-voting common stock, no group of shareholders can have special preference to receive distributions (that is, there can be no preferred stock).  If you need flexibility in securing equity financing, this restriction may limit your options.

Can you save on self-employment taxes? 

Income from an LLC is subject to self-employment taxes in addition to income taxes.  That means that all of the income you receive from an LLC, up to (currently) $113,700, will be subject to a tax rate of 15.3%.  In addition, all of your LLC income will be subject to a Medicare tax of 2.9% (or more for upper income taxpayers).  These taxes are intended to mirror the FICA and Medicare taxes paid by employees and their employers.  While half of each tax is deductible, this is still a hefty tax bite.

S-corporation owners who also work for the corporation receive compensation in their role as an employee.  Only this portion is subject to FICA and Medicare taxes.  Any remaining income to the owner in the owner’s capacity as a shareholder is treated as a dividend and taxed as ordinary income, but not subject to payroll taxes.  This can result in tremendous savings on self-employment taxes.

Obviously, this creates an incentive for owners who work for an S-corporation to pay themselves less than they deserve.  The IRS is aware of this incentive.  It can – and does – recharacterize dividends as salary when it determines that an owner has not been paid reasonable compensation for his or her work.

Who will be the owners?

There are generally no limitations on who can be an owner of an LLC or on how many owners there can be.  But that’s not true of an S-corporation.  An S-corporation must have 100 or fewer shareholders.  In addition, with a few exceptions (like estates or certain trusts), each shareholder must be an individual, none of whom is a nonresident alien.  When it comes time to find new equity investors, these rules could prove limiting.

Do you need flexibility in allocating income and losses? 

As pass-through entities, an S-corporation or LLC’s items of income, gain, loss, or deductions flow through to the entity’s owners.  In an S-corporation, these items pass-through only in direct proportion to each owner’s percentage of stock ownership.  There is no opportunity to allocate some items to some shareholders and other items to other shareholders.

Sometimes you want the flexibility to make special allocations of this sort.  An LLC taxed as a partnership allows you to do that, by putting those allocations in the LLC’s operating agreement.  Of course, this could lead to abuse, with taxpayers using the LLC as a vehicle to gratuitously transfer assets without paying gift taxes.  Consequently, there is a complex set of rules that establish when the IRS will and will not respect such allocations.

What’s your end game?

Whether it’s selling the business and retiring to the Caribbean or passing it along to your children, you probably have an idea of what the end game should be.

Under certain circumstances, a corporation can merge with, or by acquired by, another company in a tax-free reorganization.  Generally for a reorganization to be tax-free, you must receive stock of the acquiring company in exchange for your interest in the business.

These tax-free reorganization provisions apply to S-corporations, but not to multi-owner LLCs.  So, if you hope to one day be gobbled up by a large, publicly traded corporation in exchange for the latter’s stock, you’ll want to be an S-corporation. Of course, there are ways (if carefully planned) to convert an LLC into a C-corporation or an S-corporation in order to later achieve a tax-free reorganization.  But, if not done carefully, the IRS may treat the conversion and subsequent merger or acquisition as a single transaction, forcing you to pay unexpected taxes.

Can you follow corporate formalities?

One of the main reasons for incorporating a business is to achieve limited liability – limiting your exposure on debts or other obligations (including obligations arising out of tort claims) to the amount you have invested in the business.

In very unusual circumstances, a court may strip a corporation of this limited liability by “piercing the corporate veil.”  Usually this happens when a corporation’s owner uses the entity as a personal piggy bank, undercapitalizing it and treating it as a mere extension of the owner, instead of separate and distinct.

To avoid piercing the corporate veil, corporations are generally expected to follow certain corporate formalities – things like holding annual meetings of the shareholders and directors, electing officers, and preparing written minutes and corporate resolutions.  The required corporate formalities are prescribed both in the corporate bylaws or operating agreement and in any governing state statute.

Generally, LLCs are expected to follow fewer corporate formalities than S-corporations.  None of these formalities, mind you, are overwhelming.  But if you prefer to conduct the business less formally and without attention to all those procedural niceties, the LLC may better suit your style.

What are you now?

If you’ve already got a C-corporation up and running but you’d like to move towards a pass-through entity, your decision is likely easy.  Converting from a C-corporation to an S-corporation – though not without difficulties – is far easier than converting from a C-corporation to an LLC taxed as a partnership.

Under the tax code, a conversion from C-corporation to LLC is treated as a deemed liquidation of the C-corporation.  What does that mean?  It means that the C-corporation is deemed to have distributed all of its property to its shareholders in exchange for their stock and the shareholders, in turn, are deemed to have contributed this property to a new LLC.  The tax consequences can be extraordinary.  The C-corporation is deemed to have sold the property at fair market value, recognizing any gain – including any gain resulting from years of depreciation – in the process.  The shareholder, in turn, usually recognizes gain too, since the shareholder is deemed to have sold shares in exchange for property.

While a conversion from a C-corporation to an S-corporation is not without its hurdles and may come at a price, it is far easier than a conversion to an LLC.