When an entrepreneur decides to make their business official, two business entities they may commonly consider are the limited liability company (LLC) and the S Corporation (S-Corp). While these two entities have several similarities and shared benefits, they also have some marked differences. Before you decide on the right business entity for your operation, you should always explore all of your options and you may want to discuss different possibilities with an experienced business attorney in California.

What is an LLC?

As previously discussed on this blog, an LLC is similar to a partnership or sole proprietorship, however it offers additional protection for owners involving personal liability. An LLC is taxed similarly to a partnership, which means the LLC itself does not pay taxes and instead all reported profits pass through to the owners, who report them on their personal tax returns. Therefore, LLC owners do not pay double taxes on profits on both corporate and personal returns.

However, an LLC provides more protections than a partnership or sole proprietorship, as each owner may generally only be held liable for the amount of their investment into the LLC. In order to form an LLC, you must simply register with the California Secretary of State and file the required articles of organization.

What is an S-Corp?

An S-Corp is a corporate entity that qualifies for the designation of Subchapter S by the Internal Revenue Service (IRS). Like an LLC, an S-Corp is not taxed as an entity; instead, profits and losses pass through to each shareholder, who then reports them on personal tax returns. Therefore, S-Corp owners do not pay double taxes, either.

Additionally, an S-Corp provides decent protection for its shareholders from personal liability regarding the company, since the S-Corp is considered to be a separate entity from the owners and investors. (Learn more about taking on investors in this post.) In order to form an S-Corp in California, you must first incorporate in the state and then request consideration as an S-Corp.

Advantages and Disadvantages

Both LLCs and S-Corps have pros and cons that business owners should consider. The following is a side-by-side study of some advantages and disadvantages of each entity form.

LLC

S-Corp

  • Pass through taxation
  • Liability protection for owners/members
  • Flexible management structure
  • Owners must pay self-employment tax
  • Less paperwork required to form an LLC and remain compliant with the laws
  • Few restrictions on how to share profits among members
  • Can only sell interests in the LLC
  • LLC ends when owner involvement ends
  • Pass through taxation
  • Liability protection for shareholders
  • Stricter rules for corporate management
  • Owners who work for the S-Corp must pay themselves a “reasonable wage”
  • More paperwork to form and for compliance, though this paperwork may serve as valuable business records
  • Must share profits according to corporate regulations
  • Can sell stock to raise capital
  • S-Corp can survive if an owner dies or chooses to leave

As you can see, LLCs are easier to form and are much more flexible in the way they are managed. However, if you are willing to put forth the extra effort for formation and management, an S-Corp has added benefits such as possibly avoiding a self-employed tax and surviving as a separate entity after a shareholder leaves. For more info about the benefits of LLCs, check out this post.

S-Corp tax benefits can extend further than an LLC in certain situations, specifically for shareholders who work for the company. If you work for your company, you must reasonably compensate yourself, and then that compensation is taxed as wages. Any additional profits will be considered a distribution to the shareholder, and such as distribution is generally taxed at a lower rate. This often provides a larger benefit than an LLC, which requires an owner to pay the self-employment tax rate on all profits they receive.

Which is right for you?

Whether an LLC or S-Corp is better for your business depends on many different factors. For example, are you willing to forego possible tax benefits for greater flexibility for management and compliance? Would you rather jump through more hoops on a regular basis in order to receive maximum tax savings and the possibility to sell stocks? Do you foresee an end to your company or do you want it to continue after your involvement ends?

These questions and more are all important considerations for any business owner looking for a formal entity for their company. An experienced business attorney can sit down with you, learn about your preferences, and discuss whether an LLC, S-Corp, or other type of entity is right for your particular situation.

- Claire Kalia

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