Limited liability companies (LLC’s) and S-corporations* are common business entities used by business owners for the advantages these entities can provide. Business owners can reap the benefits by carefully forming and maintaining them according to state and federal laws. The two largest benefits – limited liability and tax savings – can be realized provided the new entity adheres to the law. Each entity has its rewards and pitfalls, so a savvy business owner will want to look carefully at each to determine which form is best for their business.

Formation
Both entities are relatively easy to form. In most states, all that is needed for an LLC is a simple filing that states who the owners (generally called “members”) and manages are, the membership interests, and articles of organization. A personalized operating agreement is recommended, but if none is furnished, default statutory rules will act in place of an agreement. Additionally, some states do not allow certain professionals to form LLCs. (For example, in California, lawyers cannot form LLCs.) A federal tax ID number (also called an EIN) is required for LLCs with employees.

An S-corp is only slightly more difficult to form. Articles must be filed with the state, corporate bylaws must be drafted, and the requirements for qualification as an S-corp must be satisfied. Additional tax filings are needed to elect S-corp status. An EIN should be obtained for this entity as well.

Ownership
The owners of an LLC are called members, and the LLC must have at least one member. The ownership interest in an LLC is called a membership interest. A member’s right to manage or control the LLC is proportionate to the amount of membership interest he owns.

S-corps have more owner restrictions.** While an LLC can have many types of ownership interests, an S-corp is only permitted one class of stock. The number of shareholders cannot exceed 100, and nonresident aliens cannot be shareholders. Violations of these requirements can lead to the corporation losing its S-corp status and reverting to a regular C-corporation.

Corporate Formalities
There are few corporate formalities for LLCs. Simple annual state filings are required, and it is always prudent to ensure up-to-date business records.

S-corps require regular shareholder meetings, and elections to appoint the board of directors. Annual filings, similar to LLCs, are needed as well. While this may seem arduous, small S-corps can fulfill these requirements without extensive effort. Strong record-keeping is necessary in order to preserve the benefits associated with corporation formation.

Taxes
Each of these business entities allow for “pass-through” taxation which avoids the double taxation problem of C-corps. The members/shareholders of LLCs and S-corps can deduct operating losses from their regular income which reduces the amount of taxes paid.

For S-corps, employees that own more than 2% of the corporation must pay taxes on fringe benefits. Further, S-corps must pay their employees a reasonable salary and that salary is subject to employment tax. In LLCs, the owner is considered self-employed and the entire net income of the business is subject to self-employment tax. Due to this difference, tax benefits may be realized in an S-corp because shareholders can receive income in the form of dividends that are not subject to the self-employment tax.

Employee Medicare taxes and state taxes are generally not affected by a business’s choice of entity.

Final Thoughts
All businesses are different. Their business models are different. Their goals are different. Forming an LLC or S-corp may not be the best course for every business, but benefits can be attained by the savvy business owner. Consulting a qualified attorney and a qualified account are the best ways to determine which entity is right for you.

*In the context of this article, an S-corp is a domestic corporation that has elected S-corp status.
**In small corporations, it is common for one person to be the sole shareholder (owner), a director, an officer (e.g. President, Secretary), and an employee.