Starting a business can be intimidating. One of the most important decisions to make is what type of entity to choose for your business. Two popular options are Limited Liability Companies (LLCs) and S Corporations (S Corps). But what’s the difference between the two? Let’s break it down!
Taxation of LLCs vs. S Corps:
One of the main differences between an LLC and an S Corp is how they are taxed. An LLC is a “pass-through” entity, meaning that the business’s profits are “passed through” to the individual owners and reported on their personal tax returns. This means that all profits and losses will be reported as part of their personal income, like any other form of self-employment income. On the other hand, an S corp is treated as its own taxable entity, so it must pay taxes on its profits before distributing any dividends to shareholders.
Ownership Structure Differences Between LLCs and S Corps:
The ownership structure between an LLC and an S Corp differs significantly. An LLC has members who each own a percentage interest (or units) in the company. An S Corp has shareholders who own stocks in exchange for a stake in the company. Additionally, if someone wants to become a member or shareholder in either type of entity, they must go through a more formal process than simply investing money into it. Essentially, they must meet certain qualifications set by each entity's governing document(s), such as its operating agreement. Lastly, while members or shareholders can receive distributions from either type of entity depending on their percentage ownership stake (and other factors), only shareholders can receive dividends from the company while members cannot, meaning that only profitability distributions are available for members in an LLC structure.
Formation Requirements of LLCs vs. S Corps:
Both types of entities require filing paperwork with your state's Secretary of State office, although the requirements are typically different from state to state. For example, in order to form an LLC, you need to file Articles of Organization or a Certificate of Formation that meets your state’s requirements. However, to form an S Corp you must first form an LLC or Corporation. Additionally, both types of entities require operating agreements or bylaws that outline ownership rights among members/shareholders as well as management responsibilities for each member/shareholder within the organization. These documents should always be drafted by an experienced attorney. But if you want to become an S Corp, you must also file a Form 2553 with the IRS.
How to Know Which Structure to Choose:
Electing to be taxed as an S Corp can provide significant tax benefits because owners of an S Corp pay Social Security and Medicare taxes for themselves only on their salary - not on their total profits (as they would with an LLC). Additionally, S Corps receive the advantage of pass-through taxation like an LLC, which allows them to avoid double taxation that would otherwise be present if the business was a C Corporation.
S Corp status is most appropriate for smaller businesses with one or more shareholders who are actively involved in running the company. However, there are certain restrictions and requirements associated with electing S Corp status, so it’s important to discuss your business structure with both a qualified accountant and attorney before making your decision.
When choosing which structure is right for your business, consider taxation requirements, ownership structures, and formation requirements. Additionally, having a qualified and experienced attorney and CPA on your side can help you make the best decision for you and your business. Contact us today to discuss forming your new business!