Choosing Between the S Corp and the LLC

This article is in response to the many emails and phone calls that I received as a result of the article in The Network Journal's February's issue, "The Benefits of Incorporating". Like many experts, most of readers who contacted me, agreed that either the S Corporation or the Limited liability Company (LLC) is usually the best legal form for a small business. However, there was a considerable amount of debate regarding the question on which one is the better choice.  There is no simple answer to that rather complicated question, nevertheless; in general there are cases when one form has the clear advantage over the other.

Although there are numerous benefits of forming a corporation, many small business owners chose to incorporate primarily to secure limited liability protection. By forming a corporation, the business owners effectively create a separate legal entity, which absorbs the risks of liability from business lawsuits or debts. Therefore, the incorporated business owners' personal assets are protected from liabilities arising from the operation of the business.

Even with this major advantage of limited personal liability, in the past, many small business owners chose not to incorporate because of the corporation's inherent disadvantage of double taxation. The problem here is that the regular corporation is taxed twice-once at the corporate level, and again at the personal level. Fortunately, this disadvantage was removed a few years ago when congress enacted the S Corporation elective. By filing for S corporation status with the Internal Revenue Service (IRS), an incorporated business could now be exempted from paying corporate taxes. As opposed to that of the regular C Corporation, business owners of S Corps only pay taxes from the profits of the business on their personal tax returns.

Choosing the S Corporation has the added benefit of "writing off" start up business losses. Indeed, almost all businesses will incur losses during the first few years of their operation. And unlike those of a C Corp, the owners of an S Corp are able to deduct up to $50,000 of start up losses directly from their personal tax returns each year. This is especially helpful for business owners who have other sources of income. For example, if a bank clerk earning $35,000 annually incurs business losses of  $10,000 from his part-time consulting business, he would be able to deduct the entire loss from his earnings if the business is an S Corp. Therefore, his taxable income would now be reduced by the $10,000 loss, to $25,000.

Nevertheless, because the S corporation was designed to assist small businesses, there are a number of restrictions that are in place to prevent large businesses and high net worth individuals from taking advantage of the S Corp. status. Some of these restrictions are:

• Ownership Limited to 75 Shareholders- A large company like IBM has millions of shareholders. However, an S Corp. is limited to only 75 shareholders.  Since the ownership of most small businesses rarely goes beyond a few shareholders, authentic small businesses should easily meet these requirements.

• Ownership Limited to US citizens or residents-Shareholders cannot be foreign citizens and non-resident aliens. In addition, no shareholder can be a corporation

As a result of the above restrictions, some businesses, especially those with foreign partners, are unable to take the S corporation elective.  In this case, LLC might be the next best choice of legal business entity -in that; it achieves the twin objectives of avoiding personal liability and double taxation. It is for these reasons why the LLC has become so popular in recent years

But choosing an LLC is not always the most practical decision.  In many cases the following factors weigh heavily towards forming an S corporation:

• Growth plans-If you plan to grow your business into a fairly sizeable venture with multiple investors, or you plan to raise money from the public, the corporation is a better choice. Indeed, the LLC is very easy to operate when there are a few players. However, it gets increasingly complicated to operate as the number of inventors and managers increases.

• More expensive-- Compared to an S Corp, the LLC is almost always more expensive to setup. In New York State, the filing fees for an LLC are about 50% greater than that of an S Corp. In addition, after forming an LLC, the business owners are required to publish notice of formation in two local newspapers for six consecutive weeks. These publishing fees can run in the hundreds of dollars. The S Corp does not have these publishing requirements.

• LLC does not have stocks-One of the most effective tools for attracting investors and key employees is to offer them ownership in the company via stocks. Unlike the corporation, ownership in the LLC is governed by an operating agreement, which denotes who owns what percentage of the business. With the corporate form, the degree of ownership depends on the percentage of the company's stock that you own. Therefore, if the corporation has 200 shares and you own 100, it means that you own 50% of the business. The ability to issue stocks is arguably the most important advantage of the S Corp over the LLC.

Which one to choose?
For many small business owners, if the business qualifies for the S corp., then it is usually the better choice in the long run. However, if the business fails to meet the IRS's restrictions, then the LLC is the next best choice. Nonetheless, the above analysis is limited to only a few issues. Since every situation is unique, covering every legal and tax aspects of the LLC and S corp. is outside the scope of this article. Hence, it is always best to consult your accountant or lawyer before you decide on the best legal form of business.