When launching a startup, one of the first questions that entrepreneurs may ask is, “Should I form an LLC or an S corp?”

Like corporations (C corps), LLCs protect shareholders’ assets from business debts and liabilities.

These commonly used – and commonly confused – entities can offer many advantages to small businesses of all types. They also each have some drawbacks that are important to be aware of.

In this article, we’ll cover the difference between LLCs and S corps and key pros and cons for each.

What’s the Difference Between LLCs and S Corps?

These terms are a frequent source of puzzlement for early-stage entrepreneurs trying to decide how to structure their business. Misunderstandings may arise from the fact that limited liability companies (LLCs) and corporations (aka C corps) are distinct types of business entities. In contrast, the term S corporation (S corp) refers to how an underlying business entity is taxed.

LLCs are legal entities that can be formed under state law in all 50 states. One or more members own them and may be either member-managed or manager-managed. Like corporations (C corps), LLCs protect shareholders’ assets from business debts and liabilities. But they don’t have to adhere to the same rigid structure and ongoing formalities. The LLC structure is often considered a streamlined solution for smaller enterprises looking for legal protection and the ability to grow.

S corps are businesses that elect to be taxed under Subchapter S, Chapter 1 of the Internal Revenue Code. A business can’t start as an S corp. It must start as a C corp or LLC and must meet specific criteria to make the change. S corp status can provide valuable federal tax advantages, and for many enterprises, it can be a best-of-both-worlds scenario. But it’s essential to note the requirements and limitations.

Why You Might Consider Forming an LLC

LLCs are a popular choice for several reasons:

• Compared to a sole proprietor, an LLC safeguards your assets.
• LLCs don’t need to hold board elections and shareholder meetings like corporations do.
• They are relatively easy and inexpensive to set up, with minimal maintenance required.
• There is no limitation on the percentage of total income that is considered “passive,” such as rental income.

However, LLCs aren’t always the best option. Here are a few reasons that firms might choose to incorporate instead:

• The LLC structure may restrict your ability to raise capital through the issuance of stock.
• LLCs must be dissolved if members leave, unlike corporations, which exist in perpetuity. However, many
  states will allow LLC operating agreements to include provisions that enable the LLC to exist after
  a member’s departure.
• Investors and customers may view corporations as having greater credibility or stability.

Why You Might Consider Electing S Corp Status

S corp status may offer a few valuable benefits:

• It lets corporations avoid “double taxation” by allowing profits to flow to shareholders.
• It helps LLC members avoid self-employment taxes usually imposed on profits.
• This optimized status can place you in a favorable position with lenders and investors.

But whether your firm starts as a C corp or LLC, electing S corp status has a few potential disadvantages:

• S corps are limited to 100 shareholders (no nonresident aliens) and one class of stock. (Please note that in certain circumstances, family members can be counted as a single shareholder against the 100-shareholder limit.)
• Additional rules address how the firm’s revenue is generated and allocated. For example, S corps cannot have more than 25% of gross receipts from passive income (such as investment or rental income) for three consecutive years. Navigating these rules can be complex and often requires professional guidance.
• The election process may conflict with operating agreements or articles of incorporation.

Tax Example

To better understand the possible impact of S corp election on your taxes, consider this simplified scenario:

Suppose OmniWow, Inc., made $100,000 in profit this year. That profit will be taxed at a flat corporate income tax rate of 21%, leaving $79,000 to be distributed to shareholders. Their average effective personal income tax rate is 30%, which further reduces those dividends to around $55,000 total. (This is an example of double taxation.) However, by electing S corporation status, OmniWow, Inc., could allow $100,000 to flow through to shareholders, which would then be taxed only once as personal income to around $70,000 total.

Again, this is a simplified example. Actual tax savings can vary, and consulting a tax professional is highly recommended to determine what is right for your business.

Unraveling the Complexities

The intricacies of LLCs and S corps are beyond the scope of a single article. Before making any decisions, you should speak with an accountant and an attorney who can help you understand the details and make the best choices for your unique circumstances and goals.

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For individualized advice on getting your new business off the ground, consult your financial institution.

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