Listen up, all you sole proprietors and startups out there that are working under your own name and mixing your business funds with your personal funds. There’s a lot of liability operating under this kind of structure and if you have a business deal go bad, your personal assets are going to be at risk. Making your business a separate entity just makes sense in today’s marketplace, but should you be an LLC? Should your business become an S-Corp? Which is right for you?
Shareholders Are a Major Consideration in This Decision
The initial benefit that you receive from becoming an LLC or an S-Corp is that you still get taxed the same way you would as a sole proprietor. You don’t get that double taxation penalty that a C-Corp would make you pay, although you will still be paying both your and the employer share of Social Security contributions. If you’re going to have shareholders in your business, that’s the first step in your decision here.
An LLC allows you to have foreign investors and you must be an LLC to have other LLCs invest into you. On the other hand, you can have up to 100 shareholders in a S-Corp, but they must all be either permanent residents or US citizens. Granted, for many small businesses this doesn’t matter much, but it does for some. As for the shares themselves, an LLC allows you to divide shares into common and preferred stock. An S-Corp forces a company to issue the same stock to everyone.
An LLC Gives You More Financial Flexibility
As a S-Corp, if you decide with your partners that some people deserve a better percentage of the income because they’ve been doing more work, you can’t do it at all. Whatever percentage your buy-in happens to be in an S-Corp is the percentage you’re allocated from the income of that business for income tax. On the other hand, under an LLC the income and losses can be distributed amongst all the principals in the business in whatever way everyone agrees they should be.
This means if you want flexibility in divvying up the profits and losses from your business every year, you’re going to need the LLC structure. The LLC will also let you write off more losses on your personal income than the S-Corp will, which can be beneficial in some start-up fields.
The One Thing You Don’t Want To Do…
Both an LLC and an S-Corp are what is called a “pass through organization structure.” This means that no matter what level of profit you have and no matter what you do with it, the shareholders of that organization are going to be taxed on the profits. This happens even if the profits are reinvested back into the business directly! If you plan on keeping profits from your business and you’re looking at having outside investors as shareholders, then neither format is appropriate for you because your profit-taking would result in your shareholders being taxed.
If you expect venture capital to come into your business, neither option is right for you either.
So in the LLC vs. S-Corp conversation, which one is ultimately better? That really depends on what your unique needs happen to be. If you expect any LLC or foreign investment, you’ll need to form an LLC. If not, then forming an S-Corp may be the right way to go instead.