One day, an entrepreneur went to a seminar about legal issues facing small businesses. The speaker said, “Whatever you do, you must be an LLC.” Then, the next speaker got up and said, “Whatever you do, you must be an S-Corp.” In truth, they are both right. By and large, choice of entity most often comes down to the choice between an LLC and an S-Corporation. These entities are the two main structures that offer both a single level of taxation and liability protection.
As we dive into this subject, understanding the mechanics of choice of entity is helpful. The two major drivers are liability protection and tax treatment. Liability protection is a matter of state law. Remember when Mitt Romney said, “Corporations are people, too”? Putting politics aside, that is probably a good analogy for liability protection. If you incorporate and follow the legal formalities, in determining liability, a court will view you as a separate person and will protect other people (such as shareholders) from liability. In order to incorporate, you go to the courthouse and file (or don’t file). Then, you need to be sure that you are taxed correctly. In some cases, there are no more forms to file – you simply submit the applicable return. In some cases, you need to make an affirmative election.
Let’s illustrate what is necessary for each choice of entity:
Necessary Action under State Law: None (but no liability protection)
Necessary Action under Tax law: File income and loss on personal Schedule C; no election necessary
Necessary Action under State Law: File as a limited liability corporation under the applicable state law
Necessary Action under Tax law: Default is to be treated as a partnership, which is a single level of tax; no election necessary
Necessary Action under State Law: File as a business
Necessary Action under Tax law: File S-election with the corporation under applicable state law IRS; corporation files a tax return but no tax will be due; tax will be owed by shareholders on the k-1s generated by corporation
Necessary Action under State Law: File as a business corporation under applicable state law (same filing as an s-corporation)
Necessary Action under Tax law: None; corporation. Corporation will file tax return. Any dividends made will trigger shareholder tax
Upcoming articles in this series will hopefully shed further light on the the choice of entity decision. Some of these topics include:
- LLC vs. S-Corp FICA tax: There is a potential for savings on FICA tax that is often used in choice of entity planning between LLC and S-Corps.
- LLC vs. S-Corp Factors: Companies that primarily own real estate have a different analysis than non real estate owning companies (e.g. operating companies).
- Emerging Growth and C-Corp opportunities: Because of venture capital preference to C- Corps, companies who are looking to be financed by venture capitalist may prefer to be C-Corps from the start.
- Emerging Growth and Qualified Small Business Stock (QSBS): There is a tax benefit if you qualify as having QSBS which may make being a C-Corporation more beneficial.
- Sole Proprietorship: Do you really need to incorporate? Some businesses are so small that they do not.
Assuming you are not concerned with any of the above analysis or situations, you probably are depending on your perspective either (a) free to choose between an LLC or S-Corp or (b) forced to choose between an LLC or S-Corp. One analysis you need to do at the outset is be sure you qualify to be treated as an S-Corporation. The IRS puts certain criteria in place that must be met in order to be treated as an S-Corporation. If the criteria is not met, then you are treated as a C- Corporation. Since a C-Corporation has the disfavorable double tax, more likely than not you should elect to be treated as an LLC. To quality for S-Corporation, the entity must meet the following criteria:
- Be a domestic corporation
- Have only allowable shareholders: including individuals, certain trust and estates and may not include partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have one class of stock
- Not be an ineligible corporation, i.e. certain financial institutions, insurance companies and domestic international sales corporations.
Assuming these objective criteria are met, I look at the following factors to get to an answer on choice of entity:
- Client/Accountant/Other Professional preference: Once you get down to this level, there are no wrong answers. If a professional, particularly an accountant, wants one form — go for it.
- Employee Equity: Is the business more likely than not to need or want to issue equity to employees?
- You CANNOT easily do a stock option agreement in LLC; you can do profit interest but these do not always equate with stock options.
- Does the industry have a preference or dictate the type of equity to be received?
- Note: Tech = Incentive Stock Options, needs to be done in a corporation
- Corporate Governance: LLC language is unfamiliar while corporate language is more well known. (No one really knows what a “manager” does.) Whether or not you want to have shareholder meetings, boards, etc. also determines the best choice between an LLC and an S-Corporation.
- Flexibility/Complexity. LLC have a contractual foundation, which means owners are free to contract. The contractual nature (encapsulated in an operating agreement) gives owners ultimate flexibility. But with flexibility comes complexity. Operating agreements are difficult and intense documents. Complexity equals higher professional costs. S-corps are comparatively more formulaic, less flexible (or perhaps rigid), and consequently often less expensive.
While there are no easy answers when it comes to choice of entity, and most entrepreneurs do make the wrong decision, hopefully the information we review in the coming weeks will give you a better idea of all the factors at play here.
Goodrich Law Firm, LLC
1 Although you can do it, I typically do not recommend having the LLC elect to be an S-Corp.