Understanding the Difference Between LLCs and S Corporations

Are you thinking about incorporating your small business? If so, you may be wondering which type of corporation structure will be the best choice. LLCs, or limited liability corporations, and S corporations are just two popular options you have. Both of these structures can be a good choice for a small business and both offer liability protection to keep your personal assets separate from the company. While these two entities are very similar, there are some major differences you should be aware of before you incorporate.

Do you want a simple structure?

If you’re looking for a business structure that’s less formal with more flexibility, a limited liability corporation is your best bet. Forming an LLC affords a lot of flexibility as you can choose between a member-managed or a manager-managed structure with the option to set up a board of directors. An S Corporation, on the other hand, requires the formation of a board of directions with strict record-keeping, annual reports and other important business filings. S Corporations come with a great deal of compliance responsibilities and formalities.

Who will be the shareholders?

Forming an LLC allows you a lot of flexibility in terms of who can be a shareholder as well. S Corporations may not have over 100 shareholders and all must be permanent residents or citizens of the United States. An LLC also cannot be a shareholder in an S corporation. If your business is very small this may not be a very big concern, although it’s important if you’ll have foreign owners in the business.

How is business income allocated?

With an S corporation, all income and loss is distributed to shareholders or owners in direct proportion to their share of the company. In a limited liability corporation, it’s possible to allocate income and loss disproportionately. As an example, let’s say Harry and Bill set up a business together but Bill does 70% of the work. The two agree that Bill will receive 70% of the share of the profits and losses. If the two incorporated as an LLC, this is no problem. If they made the mistake of setting up an S corporation, on the other hand, they’ll be in for a hard lesson as both will receive 50% of the income tax.

How are stocks classified?

If you incorporate as an S corporation, all shareholders have a single class of stock so you can’t set membership classes. This is another way in which LLCs offer more flexibility.

Will you think about venture capital in the future?

If you think you’ll need to raise venture capital some time in the future, remember that most firms prefer C corporations. If you begin your business as either an LLC or an S corporation, you’ll probably want to convert to a C corporation at some point. This isn’t possible in all states and it may require more fees, although the process is much easier if you begin as an S corporation.

How are losses passed through?

With both of these entities, company losses can be passed through to personal income returns. In some cases, an LLC allows for more loss pass-through, particularly with real estate investments. If you plan to invest in real estate, an LLC may be worth considering.

Both S corporations and LLCs are great choices for small business owners who are ready to incorporate. Both also offer their own advantages that you’ll want to consider before you make your choice. Keep in mind no one business entity is right for every business; the decision depends on how you want to run your company and who you want to have ownership. To learn more about incorporating your business in the United States, contact USA Corporate Services today.