The LLC v. S Corporation dilemma is one that many new business owners come across when choosing a business entity.
An S Corporation Is a Tax Status
It is important to first understand that an S corporation is not a legal entity in the same way that as an LLC, a corporation or a limited partnership entity. An S corporation begins as a general corporation under state law. The “S” is really a tax characteristic under the Internal Revenue Code. So when you are looking at your state laws for different entity requirements, you will not find the S corporation in the corporations and legal entity statutes.
What this translates to is that the only reason to be an S corporation is for tax purposes. An S corporation is a corporation under state business organization law and subject to the same formalities and requirements as a corporation. The corporation generally has more legal mandates and a less flexible structure when it comes to business operations.
An S Corproation Has Limitations and Conditions
Also, from a tax perspective, the Internal Revenue Service imposes a laundry list of requirements and limitations for an S corporation to meet in order to qualify for a single layer of taxation. On the other hand, the IRS automatically qualifies a limited liability company for such single layer of taxation without any requirements of an election or additional restrictions and limitations.
These restrictions and limitations must continually be adhered to and any deviation, even if it is accidental, will result in loss of S status. A loss of S status usually means triggered tax obligations and sometimes penalties and fees. One benefit of the LLC is that you, as a busy business owner, do not have to worry about these. It is one less set of legal compliance requirements you need to keep up with as your business evolves.
While many of these restrictions and limitations may not seem to onerous when starting a business many businesses have later found them to negatively affect their ability to grow or take on financing in later stages. It is sometimes difficult later to unwind an S corporation status if it is needed for business reasons.
An S Corporation Is Subject to Same Formalities and Requirements as a General Corporation
A corporation is simply not as flexible as an LLC when it comes to operations and ownership matters. The corporation statutes structure a corporation with a required board of directors and standard stock ownership. The LLC can alter the legal default structure of an LLC by agreeing to different arrangements in an LLC Operating Agreement.
From a non-tax perspective, the LLC clearly provides a lot more simplicity and flexibility which is important to a small business.
An LLC Can Choose S Corporation As Well for Tax Purposes
From a tax perspective, there is a difference between a default LLC tax structure (which is known as a pass through) and an S corporation tax structure. Both offer a single layer of taxation but there are some technical and sometimes complex differences when it comes to specific tax matters like the ability to take losses, the ability to allocate tax items to owners, and self employment taxes.
Now, having said this, one thing that many do not know. . even some accountants do not know. . is that an LLC can choose an S corporation tax structure if it desires. It requires meeting the same laundry list of requirements and making an election. But bottom line here is that a limited liability company can have all the state law advantages of an LLC but be taxed exactly like an S corporation if this is more suitable.
The S corporation does not have this flexibility in choosing tax structure. The LLC is a newer entity in which both state lawmakers and the federal government (Internal Revenue Service) made it a goal to be most suitable for a small business owner.
One of the many reasons that S corporations are still popular is because accountants are used to using S corporations as they have been around longer and so they advise their clients to use them. Many of these professionals have not kept up to date on the tax rules applicable to the limited liability company. Now, in some situations using corporation that has elected S corporation status may be preferred but make sure that the person advising you is experienced in both types of legal entities when conducting this analysis for your situation.