LLC vs SCorp

Should you operate out of the home or at an office? How many employees do you hire at first? How much will you be able to sell?

There are a lot of questions entrepreneurs need to ask themselves before getting their business off the ground, but one of the first and most important is how they choose to incorporate their business. There are different legal options for how they register the company with state authorities, and different designations come with different benefits and regulations. Two of the most popular designations—limited liability companies and corporations—each have advantages and disadvantages depending on what the company’s founders want to achieve.

Limited liability companies, or LLCs as they are commonly known, are a popular choice because of the protection and benefits they give to owners. The limited liability part of the name means that owners—or members, as they are called—do not have personal responsibility for lawsuits against the company or possibly bankruptcies. Limited liability companies also come with some tax benefits, like avoiding state and federal taxes and instead having members pay taxes directly through their personal income taxes. This also means that if the company suffers a loss, members can use that as a tax write-off.

This is also seen as one of the easier companies to establish. It requires only a brief form with the name of the company and names of the members, and most states have only a small fee for starting it up. Though experts say it is a good idea to have an accountant or attorney to help with these forms, and with setting up the procedures for the company like how it would dissolve and how profits are split, states keep the forms simple enough that members can do it by themselves. After the company has been established, most states have minimal annual fees as well.

Similar to the LLC in some ways, the S corporation is also a popular choice for business classification. Like limited liability companies, S corporations pass income—and the taxes that come with it—through to shareholders. So while it is classified as a corporation under the law of the state where it is incorporated, an S corporation is treated more like a partnership with it comes to taxes. This type of business is also able to avoid other types of taxes, like personal holding company tax and the alternative minimum tax. On the flip side it also excludes certain types of deductions, like ones for dividends received or certain charity donations.

The legal issues surrounding S corporations are considerably clearer than that of LLCs. The corporation has existed as a business classification for centuries, and many of the rules and regulations have been tested legally and precedence established through many court cases. Limited liability companies, by contrast, are relatively new inventions. Though they were first created more than 100 years ago in Germany, limited liability companies did not make it to the United States until the 1970s. As a result some of the legal aspects of limited liability companies have not yet been challenged in court, so there are some things that could change regarding regulations.

S corporations also have different and more stringent requirements than limited liability companies. While there are few restrictions on what kind of business can become an LLC, with really only banks and insurance companies forbidden, S corporations have a higher threshold to meet. These companies must be an eligible entity, which can include a LLC or a domestic corporation, and choose to be taxed as a corporation. They also must have fewer than 100 shareholders and must be U.S. citizens or residents. The members of a limited liability company do not even need to be actual people, but can instead be foreign entities, corporations or even other existing LLCs.

Companies that do not maintain the regulations to be an S corporation can lose their status and be reverted back to the default C corporation level. This happens if the company grows to more than 100 stockholders or if any shared are sold to a non-U.S. resident. There are also income restrictions that can disqualify a company for having S corporation status. If the company earns more than 25 percent of its gross receipts through passive income for three consecutive years in which it has earnings or profits, then it loses its status and reverts to a C corporation.

If you want to learn more about LLCs or are interested in how to complete forms to get one started, you can find more information at LLC.org.