Sole Proprietor

Should My Company be an LLC, an S-Corp, or Both?

LLC vs. S Corp: Which Is Right for Your Startup?

Selecting the right business structure can be a difficult project when starting your own small new business. Most small business advisers will tell you that a traditional C Corporation results in higher tax payments because of double taxation. However, if it's not a C Corporation, then what?

The LLC (limited liability company) and S Corporation are the latest most sought after business structures if you want to avoid double taxation. For example, with an LLC, you are taxed as a sole proprietor or partnership. This means that all company profits are "passed through" and reported on your personal income tax return of the shareholders or, in the case of an LLC, the LLC members.

However, the truth is that both the LLC and S Corp will afford legal protections such as separation of your personal assets from any judgment legal actions vs your company (whether from an disgruntled customer, debt owned to a supplier, or anyone else who has filed a legal action against your LLC or corporation).

Even though an LLC and an S corporation are similar, in some cases, they are very different. Of course, every small business is different and surely, you, as an individual may be out of the normal range, however, the following facts may help you decide what is different between these entities.

1. Keeping up with Corporate Formalities

Since an S Corporation is a Corporation, it naturally involves legal compliance, and corporate formalities such as filing a statement of the officers annually. 

The four main things you will have to do as an S Corporation are: 

1. You need to select a board of directors, 

2. File annual statements, 

3. Hold shareholder’s meetings, and 

4. Keep records of your meeting minutes. 

An LLC on the other hand uses an LLC operating agreement and in most states you do not need to file annual statement and or select board of directors nor keep annual LLC member meetings or keep LLC records of your meetings.

The meaning of this is that if you choose to set up an LLC, it will give you less corporate formality work to do each year while you will have the corporate protection as a corporation gives you.

2. Owner and Shareholders Issues

While an LLC has no restrictions whatsoever on the number of LLC member owners, the S Corporation cannot have more than 100 shareholders, who all must be either U.S. citizens or permanent residents. In addition, an S Corporation can only have individual natural persons as shareholders. The owner shareholders cannot be other corporate entities, such as an S Corporation or an LLC.

The implication is that if you file an LLC, you will be able to have foreigners as members and have as many LLC members as you want, as well as have corporation or other LLCs as LLC members.

3. Shares, Percentage of Ownership, and Owner Liability


In an LLC, you can execute an LLC agreement where the ownership, income or loss is attributed to each member based on the percentage of ownership of the member. On the other hand, an S Corp requires that that is based on the amount of shares each shareholder owner owns.

The importance of this is in the administration and allocation of profits and losses. For example, George and Susan open an online business, each owning 50% of the boutique. As time goes by, George focuses on marketing and other tasks, while Susan takes care of the day to day business operations. 

The boutique becomes a big hit, and they make a lot of money. Naturally, they want to take it out of the business and pocket it. However, Susan thinks that because she takes care of most of the online business work, she should keep most of the profits and throw a bone to George (a 50% owner) such as 30% of the profits and Susan will keep 70%.

Contention will arise in a situation such as the above. The solution is to set up an LLC and draft a flexible LLC agreement that outlines the rights, duties, percentage of profits allocated to each member and other details peculiar to the boutique so misunderstandings arise. So, if Susan thinks she contributes more and is entitled to more, she should agree and include it in the LLC agreement provided George agrees. With such a set-up with all details written down, there will be no disagreements.

In contrast, with an S Corp, you will have to split the income 50% - 50% if you have 50% of the shares of the S corporation. If you spit the income in any other way, with an S Corp, you still have to pay 50% share in income taxes of the 50% of the S Corporation's profits. That is, even if you just got only 30% of the profits.

So, if you want to be more flexible in allocating rights, duties, and profits, get an LLC instead of an S Corporation.

4. How does Income and Loss Pass-Through to Members or Shareholders

With LLCs and S Corporations, you can write off most losses as personal losses. If you are into real estate investments, an LLC has another advantage over the S Corp in that you can add the amount of the LLC mortgage to your basis for the purpose of computing a personal loss that is actually the loss of the LLC.

The implication is that even if the LLC cannot write off the loss because of high profits, you can write it off as your personal loss and save tons of money. Thus, if you have been in real estate investments, an LLC will provide more write-offs than an S Corp.

5. Voting Power, Preferred, and Common Class of Stock

In a C Corporation, you can have many different classes of stock, such as common or preferred. With an S Corporation, you can only have one class of stock, though you can have voting and non-voting shares. An LLC has something called different membership classes that you can include in the LLC agreement to avoid the "S" Corp. limitation of only one class of stock. A preferred stock entitles the holder to a fixed dividend, whose payment takes priority over that of common-stock dividends

As a result, with an S Corp, you cannot have both common and preferred stock. Thus, if you prefer to have preferred stock as described above, form an LLC as opposed to an S Corp.

6. Phantom Income and Reinvesting Profits in The Corporate Entity

Since individual owners of an S Corporation or LLC are liable for any taxes owed on the profits of the LLC or S Corp, whether the money stays in the LLC bank account or in your own personal bank account, you will still have to pay personal income tax on the profits of the LLC or S Corp.

For instance, John is an LLC member owning 25% of an S Corporation or LLC and that pass-through corporate entity has an annual profit of $100,000, John will need to report $25,000 in income in his personal tax return even if the income stays with the LLC. This is called the ghost of "phantom income" especially when you do not take that income and deposit it to your bank account, but it is retained as profits in the LLC or S Corporation bank account or other investment account.

The implication is that if you project that your company will be making and retaining more than $50,000 per year and thus pay yourself less income or dividends and leave the rest of the profits in the LLC or S Corp bank account, you may prefer to set up a "C" Corporation. With a C Corporation, you can leave the profit that you do not want to allocate as dividends or income to the shareholders in the C Corporation. Then, the C Corporation will pay income tax on the earnings retained only once and of course, you will not have to be liable for personal income tax retained by the corporation. However, most small business corporations or LLCs will not have to form a C corporation because you can expense and write off most of the profits. This is because, as discussed above, you can claim LLC losses on your own personal income tax return, in which case, it will lower your personal income tax liability.

7. Changing from S to C Corp

Some states will not allow you to change, but most will allow you to change from S to C. It may be more difficult to change from C to S corporation. For example, if you want to change from S to C, simply leave unchecked the S election and click on C on your tax return form. The other way around may be difficult in that you will have to file additional forms. In addition, if you are planning to involve any investors other than shareholders, such as venture firms, you may want to start as a C Corporation because that is the preferred legal structure among venture capital firms.

Of course, ultimately, your particular circumstances will dictate the legal structure you will choose. For example, if your business is subject to lawsuits, as a restaurant might be (e.g., food poisoning, slip and fall suits etc.) or an office environment (sexual harassment etc.) you may definitely want to incorporate or form an LLC. In addition, some states will charge you a flat annual tax fee, some as much as $800 annually (like in California), whether you're an LLC or corporation that makes any money at all. Other states, such as Texas, may charge you a high fee to file a corporation (about $300 to $400) so all these things should be taken into consideration before choosing a legal structure for your business.