Posted On Apr 08, 2015
For most entrepreneurs, the choice of business entity comes down to an LLC or corporation, since both insulate personal assets from liability claims. LLCs, S corporations and C corporations all have advantages, depending on your business goals.
Generally, the comparisons among the three will center on taxes, operating flexibility and treatment of investors and shareholders.
Here’s a quick overview of these three alternatives that will give you a starting point for considering your options before you talk to your attorney.
LLCs – flexibility and less hassle
One advantage of the LLC is the ability to choose how the company’s income will be taxed. The members have the right to be taxed as either a partnership or as an S corporation. While both of these decisions offer “pass-through” taxation (meaning that the LLC itself is not taxed on its profit), this decision does have an impact on other taxable issues, including self-employment taxes. If a company decides to be taxed as a partnership, then the entire net income of the LLC may be subject to self-employment taxes.
Another advantage of an LLC is the ability to decide how profits are to be distributed. Whether this is an advantage or not may depend on your company’s business plan. If all profits are planned to be reinvested into the company and no distributions are planned to be made to members, then this pass-through taxation may not be beneficial since the top bracket for individual income tax is nearly 40 percent, while the effective corporate rate is about 15 percent. However, if distributions are planned, then the pass-through taxation avoids paying both the corporate tax and then personal income tax on the income distribution.
There are default state rules for LLCs, but organizers also are allowed to pen a more detailed operating agreement that can cover such things as rules for selling or transferring ownership interest, how financial reports will be handled, voting rights, members’ role in management, members’ rights to distributions, and what happens if a members’ interest is foreclosed upon and ends up being owned by a creditor.
The customization offered by the operating agreement may be the primary reason to choose an LLC, and you should definitely draw it up in consultation with an attorney.
LLC members – what we would call shareholders in a corporation – are all treated equally. That means there is only one class of ownership interest, unlike a C corporation, which can have preferred shares that receive preference in dividends. In most cases, that’s a non-issue, but passive investors in an enterprise may be more willing to participate if they have priority in distributions.
For many start-ups, a big draw of the LLC is that it’s easier to run and there are fewer record-keeping requirements. Corporations require many formalities such as annual meetings, election of officers and a board of directors, and adoption of bylaws. These corporate formalities are not required of an LLC, leaving owners more time to concentrate on running the business.
However, that isn’t to say some formality isn’t useful. We always advise LLCs to voluntarily adopt some of the formality of a corporation. The discipline is good for the business, and it will help the members feel comfortable with the company and build a stronger defense if a litigant should attempt to “pierce the corporate veil” – that is, make LLC members personally responsible for LLC debt or liability.
One significant caveat on LLCs: some courts have ignored the corporate form for single-member LLCs for non-operating companies used simply to shield assets from creditors.
S corporation – a hybrid option
Like an LLC, an S corporation has pass-through taxation, and it has an additional advantage: a manager-shareholder can take a salary, plus additional income in dividends. Unlike the salary, the dividends won’t be subject to Social Security and Medicare taxes, and, depending on your personal situation, that may create an overall tax savings. As is discussed above, an LLC can choose to be taxed as an S corporation.
An S corporation has only one class of stock, and it must adhere to all the formalities of a traditional corporation. For investors who aren’t involved in the day-to-day operations of a company, those formalities may be comforting, because they provide for stricter financial controls and oversight.
The “corporate-lite” nature of an S corporation is balanced by several restrictions that don’t apply to either LLCs or C corporations. An S corporation is limited to 100 individual shareholders and they must be U.S. citizens. Other companies and corporations cannot own S corporation stock.
C corporation – if you’re thinking “big”
The C corporation is the “traditional” incorporated business, and it has the strictest formalities. There is no pass-through taxation, meaning all income being taxed at the corporate rate. Thus, manager-owners will see profit taxed first at the corporate level, and a second time when it is distributed to them as dividends or salaries. Once it reaches a certain size, a C corporation must use accrual accounting, a more complex system that likely will increase expenses.
One big advantage of a C corporation is that it doesn’t have to distribute profit at the end of the year. The C corporation can retain earnings, investing them in the business, paying debt or holding them for future distribution to shareholders. While an LLC and S Corp also do not have to distribute profit, due to the pass through taxation, the members or shareholders in these situations would face “phantom income” from the profit of the company with no distributions to cover the taxable liability.
As mentioned earlier, a C corporation can issue preferred stock, which may encourage investment, and there are no restrictions on who can own stock.
If you see a public offering in your future, a C corporation will place you in a better position to satisfy the reporting requirements of the Securities and Exchange Commission. An acquirer that is a public company will also find it easier to integrate a target company that already is maintaining corporate formalities.
We recommend as the starting point for selecting the right entity is talking to your attorney about your long-range plans and goals for the business. While you can be successful with any business entity formation, the right choice will maximize tax savings, accommodate the inevitable changes that will come to your business, and save you aggravation and money.
Mark Goddard is a shareholder at Turner Padget, where he has an active litigation practice specializing in business and corporate litigation, complex insurance litigation matters and probate litigation. He has extensive trial and arbitration experience, and has taken over 25 cases to verdict in venues throughout South Carolina. He may be reached at (843) 213-5542 or by email at firstname.lastname@example.org.