As an entrepreneur, you’re making important business decisions every day — from your logo and branding to your broadband provider. But choosing your legal business structure is a critical decision…one that will impact the taxes you pay, your ability to raise capital, how much paperwork you’ll have to contend with, and the personal liability you face.
So how do you know what business structure is right for you?
There are numerous legal business structures to choose from, but I’m going to focus on the three most popular forms: the Limited Liability Company (LLC), S Corporation (S-Corp) and the C Corporation (C-Corp). In this post, I’ll be comparing the differences between the LLC and S-Corp, and stay tuned for a review of the S-Corp vs. C-Corp.
Let’s start with some basic definitions:
- LLC: An LLC is a hybrid of a partnership and corporation. There are no shares. An LLC’s main benefit is to limit the liability of the owners. For example, personal property is separated from company property, and can’t be wiped out because an unsatisfied client sues your company or your business runs into financial trouble because a key customer fails to pay. An LLC does not file separate taxes (in the case of a single member LLC, the LLC taxes would be filed under the individual members’ tax returns; in the case of a multi-member LLC, the LLC would generally file a partnership tax return). All company profits flow through to the owners and are taxed at the personal income rate.
- S Corporation: An S Corporation actually starts off as a C-Corp and then soon after incorporation, the owners submit Form 2553 to the IRS to be treated as a pass-through entity. Like a regular corporation, an S Corp is a collection of stockholders who share company ownership. But in this case, the income/loss of the company is passed through to each shareholder’s personal tax statement.
Now what does all this mean for you and your business? While circumstances vary among individuals and individual businesses, here are some general guidelines to help you understand the differences and their impact.
The LLC is ideal for companies that don’t want or need much formality, but still want legal protection. In a corporation (S-Corp or C-Corp), Articles of Incorporation must be filed; bylaws have to be written; officers have to be named; a board of directors elected; and minutes must be filed and resolutions passed whenever you want to make changes to the company. In the LLC, this isn’t the case. LLCs just use an informal ‘operating agreement’. Depending on your particular type of business, this could either be a great time and money saver, or the gateway to potential conflict down the road.
Both LLCs and S-Corps are considered pass-through entities when it comes to federal income tax. This means the business itself is not taxed; rather, any business income or loss is reported on each individual owner’s tax return (please remember…it’s wise to consult with a tax advisor on your own situation…).
Here’s where the two structures differ. In an LLC, income and loss can be allocated disproportionately among the owners; in the S-Corp, income and loss are assigned to each shareholder strictly based on their pro-rata share of ownership.
So, if I own 80% of an LLC, my share of the tax burden doesn’t necessarily have to be 80% of the taxable income. But if I own 80% of an S-Corp and that company makes $100,000 in taxable income, I will be taxed on $80,000 of income…even if I never withdrew a cent from the corporate bank account.
Therefore, consider first whether you will make a profit soon after incorporation. If you are going to reinvest that profit back into your business, then an S-Corp might be right for you. However, if you’re going to distribute that profit to yourself and any shareholders, you should think about the LLC, or perhaps the C-Corp which is not a pass-through entity.
Of course, your decision will ultimately depend on all the unique aspects of your particular business needs, vision, and circumstances. But regardless of your business type, taking a serious look at your legal structure is important and will help you scale far more smoothly and avoid any legal pitfalls in years to come.
Nellie Akalp is the CEO & Co-Founder of CorpNet, Incorporated, her second incorporation filing service company based on the simple philosophy of truth in business and her strong passion to assist small business owners and entrepreneurs.