It’s almost as if the easy part was the actual creation of the business from the inside of your mind when for most professionals that’s often the hardest part of the game. Why would it be so easy? Because you’ve only just begun with the journey of starting your own company. You then are faced with the paralyzing question of what kind of legal business structure should you file?
In particular, there are two types here that get most people confused: that’s the LLC (Limited Liability Company) and the (S) Corporation. They’re quite similar, but with some subtle differences resulting in monumental situations that could either make or break your business. Knowing which structure might fit your needs is crucial to your success.
First Off, Though, We Can Examine the Similarities From a Positive Standpoint
Both structures carry the same main benefit: you’re not held liable for assets that belong to you. That means if you invest in certain personal assets to the company, just in case there’s some lawsuit in the horizon, waiting to grab your cash, what’s yours (not the company’s) is protected. Essentially, a veil is drawn between you and the corporation. You are not the corporation.
Additionally, you can avoid paying both personal and corporate taxes with both structures, not to mention pre-tax expenses, such as uniform costs, computers, travel, phone, advertising, promotions, gifts, mileage and healthcare can be written off.
There are some differences, though….
Understanding the Contrast Between the LLC and the (S) Corporation
For starters, an S Corp is a structure allowing the owners of the actual company to pay themselves their actual salaries plus dividends resulting from any additional profits. An LLC, though, simply operates as a “pass-through entity,” filtering all expenses through personal income tax return, and the remainder acts as the owner’s own profit from the company.
What’s good and what’s bad between those two concepts? It depends on the business, the needs of the owner(s) and maybe even the industry. It’s tricky.
We’ll break it down for you, though. Each structure does have certain pros and cons, starting with….
The LLC — the Good Stuff
A lot of professionals tend to like the LLC. it’s flexible, malleable, adjustable, adaptable. Moreover, the owner of an LLC doesn’t even have to file a separate tax return for the company. It’s convenient.
This structure’s also quite easy to set up. All you basically need is a page of information, a form you file with the government, not to mention it may only take a couple hundred dollars to get it all legal. The flexibility often comes up with the ability to have savings within the company, such as with accountants and attorneys if you plan on contracting with them for any reason.
On the Other Hand…. The Bad Stuff?
This may turn you off, but you will, in fact, have to pay a self-employment tax. This is why some people consider an LLC a “hybrid” of a corporation and proprietorship. You’re basically a 1-man operation, hence you’re self-employed, but you have the makings and structure of an actual “company.” You still, however, have to make those quarterly estimated payments to the IRS just for being self-employed.
Additionally, penalties can be incurred if you operate the LLC anywhere close to where you’re operating your personal affairs. The LLC is a separate construct. It shouldn’t be a shell for some of your personal agendas. This can be quite the difficulty given the case that it is a hybrid formation. You’re technically the owner and the business, but legally both concepts need to be different, or else you lose your protection afforded by the legal structure.
(S) Corporations, However, Provide a Different Outlook
The benefits revolve around the taxes for this. While the LLC emphasize convenience, the benefits may really be quite financial here with this formation. You get what are called distributions, excess profits after salaries to employees have been paid, plus all payroll expenses, federal taxes and FICA have been divvied out.
The distributions are considered “extra” for the owners. That’s a good thing.
However…. Be Wary of the S Corp
It’s essentially nowhere near the resemblance of a self-employed proprietorship, hence its link to the other similar formation, the corporation. There are stricter guidelines with this, such as the fact that you do have to be a resident or U.S. citizen. You also can’t have more than 100 shareholders, and that includes a spouse.
Investments can be a bit tough with an S Corp over the fact that you’d only be allowed to have one class of stock, plus profits and losses end up evenly distributed according to the proportion of each shareholder’s interest in the company. It simply means this: if a shareholder owns, say, 50% of the company, that shareholder would then expect 50% of either profits or losses. Call it a gamble, if you will.
Additionally, it’ll cost more out of your pocket to successfully form that S Corp with the government, and the requirements for shareholders are pretty ironclad with a serious risk of dissolving protection if they don’t abide by the laws of the formation. Before you know it, your S Corp may end up being a “C Corp,” which is the standard. If you don’t want that, make sure your shareholders follow the rules.
Other restrictions include passive income limitations of more than 25% of gross receipts, additional state taxes and scrutiny with “reasonable” salaries paid to shareholders. This does sound like a lot to deal with, but understand that sometimes the benefits may outweigh the disadvantages, such as….
Firstly, Why an LLC Might Work Well
If you happen to be a new business owner, especially for a business operating online, the LLC might be a great choice for you. It’s such an adaptive and malleable structure in business that you could easily even be taxed as an “S Corp” while still maintaining your LLC formation.
The reason why you might want to do that, though, is on the possibility that your revenue grows substantially. As a rule, an LLC will pay more taxes based on growth in revenue. As an S Corp, though, you’ll be allowed to pay yourself a “reasonable” salary based on your specific industry, whatever that may be, and you’ll reap the benefits in monthly dividends due to extra profits coming in.
There’s flexibility there. The S Corp is all about tax time. As an LLC, you’re actually still able to reap from those financial benefits of an S Corp while still maintaining the LLC’s legal leniency benefits.
On the Other Hand, Maybe You Need to File for an S Corp
Perhaps you’re growing faster and faster — and faster. If that’s the case, you may need to bring in investors, possibly sharing in the ownership of the company with your employees. If that’s the case, the (S) corporation might be the better fit for you.
Part of the reason for sharing ownership, though, isn’t necessarily because of how big your company’s getting. Rather, you want to separate the corporation from you as much as possible. the better you’re doing, the worse you could be if something bad happens. If by chance something bad happens, it only happens to the business. Not you.
There is, of course, more paperwork involved — the S Corp will require you to manage those mandatory meetings, record the minutes, elect some officers and even supply the government with your formal financial statements. In the end, though, it’s all worth it, because your substantial growth in business will be legally protected.
The Choice Is All Yours
The important choice to make here, though, is clear: you consult with your qualified business lawyer. You see the benefits and weaknesses of both structures, the LLC and (S) corporation, but you may not know how to apply those molds to your own business. You may not even know whether or not you’re more like an LLC or (S) corporation. No worries: that’s when legal counsel will come in handy.
For starters, though, you’re on the right foot. The rest is up to you.
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Matt Faustman is the CEO at UpCounsel. You can follow his business insights on Twitter at @upcounsel.