by Leslie Jones
Having made the decision to incorporate, it is essential that small business owners choose the correct form. Two of the most popular business entities for small business in the United States are Limited Liability Companies (LLCs) and subchapter S Corps. There are advantages and disadvantages to each form, and this post will provide a broad overview of the major differences.
Both S Corp and LLCs are distinct legal entities. Both forms furthermore protect the assets of the owners—shareholders of both LLCs and S Corps are typically not personally responsible for the debts and liabilities of the entity. Both LLCs and S Corps are also considered to be “pass-through” tax entities. Income or loss generated by the company is therefore reflected on the personal income tax returns of the owners, thus avoiding double taxation.
Properly speaking, the S Corp is not a distinct business entity as much as a tax status—“S Corp” refers to corporations that choose to be taxed under subchapter S of the tax code. Many of the advantages that come from obtaining S Corp status can be realized simply using the LLC form. However, there are some tax advantages to incorporating as an S Corp from which LLCs do not benefit. The most important has to do with way in which business income is taxed. Generally, owners of an LLC are subject to employment tax on the entire net income of the business. Owners of S Corps, on the other hand, are allowed to be paid a salary. Under this form, therefore, only the wages of the owner are subject to taxation. The remaining income is treated as a distribution, which is taxed at a lower rate. The IRS does try to attempt to monitor and prevent fraud by requiring that owners of S Corps be paid a reasonable salary. S Corp owners who pay themselves a token salary to avoid the higher tax rate may have their distributions reclassified as wages.
The more significant disadvantage to incorporating as an S Corp has to do with the ownership and operation restrictions placed on the form. For instance, an S Corp can have no more than 100 shareholders. It may also not have any shareholders who are non-US residents. Unlike S Corporations are also not allowed to be owner by other corporations, certain types of trusts, LLCS, or partnerships.
Also unlike LLCs, S Corps are subject to a series of formal requirements regarding their operation. S Corps must adopt bylaws and have an appointed board of directors, who meet regularly and keep minutes. As a consequence, ownership stakes in an S Corp are not as freely transferable as those in an LLC, as transfers require the consent of the board.
Of course, a general overview is never a substitute for detailed advice from a lawyer or accountant. For many small business owners, the regulations and restrictions associated with S Corp status will not be worth the hassle. However, small business with fewer than 100 shareholders may want to consider the benefits of incorporating as an S Corp.
For more information contact Leslie Jones at 914-725-4800 or email Leslie.