What’s This?

By Nellie Akalp 2012-02-17 13:29:06 UTC

Choosing the right business structure can be a daunting task for the small business owner or entrepreneur. You may have heard that the traditional C Corporation is overkill for most small businesses, and results in higher overall tax payments through something known as double taxation. But if the C Corporation isn’t right, then what is?

In my last post, I discussed how the LLC (limited liability company) and S Corporation are popular structures for small businesses since they avoid this double taxation burden. With these business structures, the company is taxed like a sole proprietor or partnership, meaning the company itself doesn’t file its own taxes; all company profits are passed through and reported on the personal income tax return of the shareholders or, in the case of an LLC, the members.

Most importantly, both the LLC and S Corp will separate your personal assets from any liabilities of the company (whether from an unhappy customer, unpaid supplier, or anyone else who might pursue legal action).

The similarities between these two business entities are significant, but the differences can be even more striking. While circumstances vary for each individual and his or her business, here are some general guidelines to help you understand the differences and their impact on your business.

1. Business Formality

With its roots as a C Corporation, the S Corporation involves structure, formalities and compliance obligations, which can be too burdensome for the solo entrepreneur, in other words, a “payroll of one.” If you incorporate as an S Corporation, you need to set up a board of directors, file annual reports and other business filings, hold shareholder’s meetings, keep records of your meeting minutes, and generally operate at a higher level of regulatory compliance than your business might need or want to deal with. With the LLC, this isn’t the case. LLCs just use an informal operating agreement.

What to know. If you want less red tape and formality, the LLC can provide greater simplicity.

2. Who Can Be a Shareholder?

The S Corporation has more restrictions in terms of who can be a shareholder. For example, an S Corp cannot have more than 100 shareholders. Of course, this limitation is probably not of much consequence to many small businesses. In addition, all individual shareholders of an S Corp must be either U.S. citizens or permanent residents.

What to know. If you have foreign owners (or would like an LLC to be a shareholder), you cannot form an S Corporation and should opt for the LLC.

3. Income Allocation

In an LLC, income and loss can be allocated disproportionately among the owners. By contrast, in the S Corp, income and loss are assigned to each shareholder strictly based on their pro-rata shares of ownership.

This is an important distinction to understand. For example, let’s say Sally and Heidi open a micro-brewery, each owning 50%. As the year progresses, Sally needs to focus her time elsewhere, while Heidi does all the work. Their business becomes more profitable than they ever imagined, and they want to divide up the profits. Because Heidi has put in the bulk of the work, the two decide she should keep 75% of the profits, and Sally should get 25%.

With an LLC, this type of agreement is fine. The two owners simply agree to the arrangement and they will be taxed accordingly to their operating agreement.

But this type of flexible arrangement won’t work with an S Corporation. Because Sally and Heidi are each 50% owners, each will be allocated 50% of the corporation’s income, at least when it comes to computing income tax.

What to know. If you need flexibility when it comes to divvying up profits among owners, the LLC is the preferred structure.

4. Pass-Through Losses

With LLCs and S Corporations, members and shareholders are able to pass company losses to their personal income reporting. In some circumstances, the LLC lets you pass more loss than in an S Corporation, most notably when it comes to real estate. In an LLC used for real estate investments, members are allowed to add the amount of the mortgage to their basis for the purpose of computing a loss. Clearly, that can add up to a significant difference in your tax statement.

What to know. If you’re setting up a business structure for real estate investments, the LLC lets you write off more losses on your personal tax reporting.

5. Class of Stock

In an S Corporation, all shareholders own only one class of stock. An S Corporation can have voting and non-voting shares, but cannot have distinctions like common stock and preferred stock. In an LLC, however, these priorities and preferences are allowed, and you can have different membership classes.

What to know. You cannot offer common and preferred stock classes in an S Corporation. Thus, if you’d like flexibility in ownership classification, go with the LLC.

6. Reinvesting Profits

There’s another twist regarding the LLC, S Corp and your taxes. As pass-through entities, individual owners of an S Corporation or LLC are liable for any taxes owed on profits — whether that money is retained in the company or put in their wallets.

For example, if you own 50% of an S Corporation or LLC and that company makes $80,000 in profit, you need to report $40,000 in income on your personal tax return. And it doesn’t matter whether that $40,000 actually ended up in your pocket. This is known as “phantom income,” and can obviously cause a problem for some shareholders.

What to know. If you plan on retaining money in the company (and would prefer not to have shareholders be personally taxed on this money), you should consider the C Corporation over both the LLC and S Corp. Of course, your specific situation may vary, so it’s always best to consult your accountant.

7. VC Funding

If your company is considering raising venture capital down the road, VC firms will most likely choose the C Corporation as the type of legal entity for their investments. This doesn’t necessarily mean your business needs to start as a C Corp, but be advised: If you are considering raising venture capital and start out with an LLC or an S Corp, you will need to convert the business to a C Corp (if your state allows conversions) at some point. This conversion will require additional filings and fees within your state. If you choose this route, you may want to consider the S Corp as your option, since converting an S Corp to a C Corp can be done in a day with a single tax form (you’re basically unchecking the box for S Corp tax election on an IRS form).

Choosing the right business structure is a multi-faceted decision, and will ultimately depend on all the unique aspects of your particular business needs, vision and circumstances. And remember that tax treatment varies between states.

Consulting with an accountant or tax advisor can go a long way in helping you determine which business structure offers the biggest advantage for your situation. Take note that the deadline to elect S Corp treatment is March 15 for existing companies (or 75 days from the day your company is formed). Get your legal structure squared away early on, and your company will be set for years to come.

Nellie Akalp is the CEO of CorpNet.com. an online legal document filing service, where she helps entrepreneurs incorporate or . More