Forming an LLC? Why not an S Corp?

Founders may form many types of entities, including partnerships and regular corporations (C Corps), but two of the most popular types are limited liability companies (LLCs) and Subchapter S corporations (S Corps).

Generally speaking, LLCs and S Corps are entities that allow profits and losses to be passed through to the owners of the entity, and not recognized on the entity level.

An LLC is formed by filing a certificate with a state’s secretary of state. You can find out more about that by clicking on this simple guide.

An S Corp also starts its life as a state-filed corporation. But it then makes a federal filing to elect to be treated as an S Corp for federal income tax purposes. The election is made once, but care must be taken to insure the eligibility requirements for the election continue to be met.

In order to meet the eligibility for election, the corporation (a) must have only one class of stock, (b) must have no more than 100 shareholders and (c) the shareholders must only be individuals, certain trusts and certain tax-exempt organizations.

The profits of C Corps are taxed twice, first on the entity level and then again, with respect to dividends, on the shareholder level. One of the primary benefits of the LLC and S Corp is that profits are not recognized within the S Corp, but are instead only recognized by the S Corp’s shareholders. This avoids the double taxation of C Corps.

On it’s face, an LLC may appear to be a better choice than an S Corp. Among the reasons:

  • LLCs may have many classes of ownership interest, allowing the entity to allocate income and losses as it sees fit; S Corps, only one
  • LLCs may be owned by just about anyone; S Corps, only be owned by individuals and certain trusts and tax-exempt organizations
  • The internal rules governing LLCs are less strenuous than those of S Corps
  • LLCs are generally not subject to state income taxes; S corps may be

However, the S Corp can have certain advantages over an LLC:

  • Some states offer certain tax benefits to corporations, but not to LLCs
  • The owners of an S Corp can avoid a certain amount of self-employment tax by distributing some of the profits as dividends. These dividends are not subject to self-employment tax such as social security and medicare taxes. In an LLC, dividends are not available. All profits are subject to self-employment tax. The savings in taxes can be significant, especially to a small company.

It’s worth spending some time deciding whether to form an LLC or an S Corp. So get some learned advice from your lawyer or accountant.

Any questions? Please reach out.