Business entities are used and important for a number of reasons, primarily for tax opportunities or benefits and limiting personal liability. Currently, the two most popular business entities for small, privately owned businesses are Limited Liability Companies (LLC) and S Corporations, wherein a closely held corporation makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.
One of the most important features and advantages of both an LLC and S Corp is that the entities will separate one’s personal assets, as a member (LLC), shareholder (S Corp), or other officer, from any liabilities of the company, generally protecting those personal assets from legal action or creditors. The liability is general limited to the funds put into the company and the value and assets it holds.
It is important that business owners, officers, members, and shareholders recognize that while generally the business entity structures will protect them from individual liability, there is an exception. This exception is generally referred to as “piercing the corporate veil”, wherein, due to fraudulent or other statutory impermissible business behavior or structure moves (such as underfunding a section of the business to avoid liability or not securing the requisite insurance), the courts will then allow the plaintiff to bypass the business entity liability protections and pursue the individual(s) behind the business for recovery, in addition to the business entity.
Tax Advantages and Implications:
LLCs and S Corporations are also popular structures for small businesses because they avoid double taxation. This means that these companies are taxed like a sole proprietor or partnership, so the company itself doesn’t file its own taxes; instead all company profits are “passed through” to members (LLC) or shareholders (S Corp) and reported on the personal income tax return of those individuals. As pass-through entities, individual owners of an S Corporation or LLC are liable for any taxes owed on profits — whether that money is retained in the company or put in their wallets. Both LLCs and S Corps can also deduct pre-tax expenses, such as travel, uniforms, computers, phone bills, advertising, promotion, gifts, car expenses, and health care premiums.
Further, in an LLC income and loss can be allocated disproportionately among the owners. This creates more flexibility to control and run the business as the members see fit, or is needed for success. By contrast, in an S Corp, income and loss are assigned to each shareholder strictly based on their pro-rata shares of ownership, at least when it comes to computing income tax.
With LLCs and S Corporations, members and shareholders are able to pass company losses to their personal income reporting. In some circumstances, the LLC lets you pass more loss than in an S Corporation, most notably when it comes to real estate. In an LLC used for real estate investments, members are allowed to add the amount of the mortgage to their basis for the purpose of computing a loss.
Two additional key advantages of an S Corp are that it offers tax benefits when it comes to non-dividend distributions and corporate losses can flow through to owners. However, an LLC can elect to be taxed as an S Corp while retaining the structure of an LLC. Single member LLC owners are required to pay self-employment tax on income generated in the LLC, which means making quarterly estimated payments to the IRS.
The S Corporation involves more burdensome structure, formalities, and compliance obligations than an LLC. If one incorporates as an S Corporation, they need to set up a board of directors, file annual reports and other business filings, hold shareholder’s meetings, keep records of meeting minutes, and generally operate at a higher level of regulatory compliance. With an LLC, this isn’t the case. LLCs are able to just use an informal Operating Agreement.
The S Corporation also has more restrictions in terms of who can be a shareholder, while there are no analogous member requirements for LLCs. An S Corp cannot have more than 100 shareholders and all individual shareholders of the S Corp must be either U.S. citizens or permanent residents.
In an S Corporation, all shareholders can own only one class of stock. While in an LLC, there can be different membership classes and priorities, and preferences are allowed.
The type of company looking for S Corp entity status is one that is likely to be a fast-growing businesses planning to bring on investors or share the ownership of the company with employees. An LLC provides more control to the owners/members, but does not provide the flexibility of share options to investors. Generally an LLC would need to secure a loan or share ownership interest or percentage with investors, while an S Corp would be able to create and sell shares for investment, in addition to other traditional investment opportunities. But an LLC can elect to be taxed as an S Corporation.
Forrest P. Merithew, Attorney at Law, works with a range of entrepreneurs, investors and small business think tanks, as well as business developers and owners themselves. He has experience developing business entities, amending business entities and related filed document status, and consulting with businesses owners and developers regarding their goals, potential liabilities, partnerships, investing, contracts, and statuses. Forrest P. Merithew is not a tax professional and would recommend that any developing business and owner talk with a tax professional, such as a CPA to determine which business entity structure would be best for their business financially. Forrest Merithew works with a range of business types, including but not limited to, recreation and adventure; construction, real estate, and development; gear and product developers, manufacturers, distributors, and retailers; medical and device companies; artists; breweries, restaurants, hotels, and more.