When discussing choosing the right business entity, it’s important to understand the significant (and subtle) differences between the various choices. Today’s post details the differences between the limited liability company (LLC) and the S corporation.
State v. Federal Distinction
For state law purposes there are two primary entities that merit consideration: corporations and LLCs. Corporations and LLCs both offer limited liability to business owners, which means that absent extraordinary circumstances if the business is sued, only business assets are on the hook—i.e. your personal assets would be safe from any judgment.
For federal tax purposes there are three primary entities: C corporations, S corporations, and partnerships. LLCs are, by default, taxed as partnerships unless the business owners elect to be taxed otherwise.
Corporations can elect to be taxed as a S corporation, instead of the default C corporation tax status. As an S corporation, the company is taxed as though it were a partnership, i.e. it receive pass-through taxation treatment. With pass-through taxation, the taxable income is passed through the business entity to its owners, at which point it is taxed only once at the owner-level. For a variety of businesses, this tax structure is more advantageous than the default double taxation of corporations—the income is taxed once at the company level and then again when the money is distributed to its shareholders.
One of the major distinctions between LLCs and S corporations is the governance of the business. In general, corporations are owned by shareholders, shareholders elect a board of directors, and the board appoints officers. Officers typically manage the corporate activities of the business. Corporations are subject to a number of statutory requirements (RCW 23B), e.g. corporations are required to hold initial and annual shareholder meetings.
On the other hand, LLCs are owned and operated by the members—owners of an LLC are considered “members.” Members can elect to manage the business or they can appoint a manager to operate the business. LLCs tend to be more flexible to manage and operate since there are fewer statutory requirements. Furthermore, LLCs are able to choose how the company will be operated by drafting a custom operating agreement, rather than using the default rules set out in RCW 25.15.
Dividends, Distributions (Taking Money Out)
Another distinction is how owners of the company can take money out. In a S corporation, shareholders can be employees of the company and be paid a salary. Also, corporations can elect to give cash (or stock) to its shareholders in the form of dividends; however, there are certain restrictions on the timing and amount of dividends, as well as who must receive the dividend, i.e. all shareholders.
In an LLC, the company can provide money to its members in the form of distributions. Distributions are paid out according to the terms of the LLC’s operating agreement, which can provide extensive limits on distributions or no limitations at all. Again, LLCs allow for greater flexibility when it comes to distributing company cash to owners.
One important note is that distributions to employee-members of an LLC are subject to self-employment tax rates, while employee-shareholders of an S corporation have the ability to take reasonable salaries without being subject to high self-employment taxes.
Additional S Corporation Restrictions
If you elect to be taxed as an S corporation, you are required to adhere to a number of restrictions or your company will automatically convert to a C corporation. S corporations can only have one class of stock, cannot have more than 100 shareholders, and cannot have shareholders that are corporations, LLCs, partnerships, or certain trusts. Failure to comply with these requirements may result in significant tax consequences when your business is converted (automatically) to a C corporation.