Is an S Corporation or an LLC Right for Your Business?

The question we get asked most often by new business owners is “Should I form an S corporation or a limited liability company?”  Just what are the differences between an S corporation[1] and a California LLC?  There are advantages and disadvantages to both, so the decision as to which one is best for your new business will depend on your individual circumstances and goals:

Owner Liability

The main advantage of both types of entities is the degree of protection that each provides to its owners.  If the business is properly run, and all legal and financial corporate formalities are carefully observed, then the owners are insulated from liability for business taxes, torts, and debts. This protection is probably the main advantage that both LLCs and S corporations have over partnerships, associations, and sole proprietorships.[2]

Type of Business

Almost any type of business can form an S corporation. Banks, insurance companies, and foreign corporations are types of businesses that cannot elect to be taxed as an S corporation, and there are certain restrictions on the type and number of shareholders that the corporation can have (see below.)

Generally, California licensed professionals (attorneys, accountants, architects, doctors, and so forth) are not eligible to form LLCs.   Some licensed businesses, such as locksmiths and hair salons, can operate as LLCs.  State law has recently relaxed this restriction, now leaving the decision up to the individual governmental regulating agencies.   Licensed contractors are now for the first time permitted to form LLCs, and other licensed professions may follow suit in the future.

Ownership.

LLC owners (members) can be any individual or entity, and an LLC can have any number of members. 

S corporation owners (shareholders) are limited to natural persons (none of which can be non-resident aliens), estates, tax-exempt organizations, and certain trusts.  An S corporation must have no more than 100 shareholders, and all of the shareholders must consent to the S election.   

Either type of entity can have only one owner.

Management

California corporations are required to have at least a president, secretary, treasurer, and a director (or more directors, depending on the number of shareholders.)  The shareholders elect the directors, and the directors in turn elect the officers.  The officers of the corporation are responsible for the day to day operations of the company business and answer to the directors and the shareholders. 

LLCs can be managed either by manager(s), or by one, some, or all of the member(s).  There is no requirement that an LLC have officers, but LLCs are not prohibited from electing them, either. 

Maintenance

California Corporations Code requires that shareholders hold meetings at least once a year, and most bylaws require periodic director meetings and that meeting minutes must be kept. The law does waive the meeting requirement if issues normally covered at the meetings are consented to by written consent. 

There are no legal requirements for LLC members and/or mangers to have regular meetings or that meeting minutes be kept. It is recommended, however, that multi-member and manager-managed LLCs have periodic meetings to promote smooth and proper operation of the business.

Profits and Losses

Profits and losses are distributed to corporate shareholders based on the number of shares held by each. 

LLC members, however, can agree to distribute profits and losses on a basis other than percentage of ownership, taking into account such factors as the number of hours or level or expertise that each member contributes to the LLC business.

Taxes

S corporations are “pass-through” entities, meaning that the income is taxed only once as it is distributed to the owners. 

The same holds true for LLCs.  A single member LLC is treated as a “disregarded entity” in which the income is reported and taxed on the member’s personal income tax returns, and a multi-member LLC is taxed in the same manner as partnership income is taxed.  An LLC can elect to be taxed as a corporation, but this is not common.

In an S-corporation, only the salaries paid to officers and employees are subject to self-employment taxes. 

Members of  LLCs, however, are subject to self-employment taxes on both salaries and profits.  If the owners of the business do not intend to take a salary and there will be no employees, such as when the LLC is formed just to hold title to real estate, then this is not an issue.

Many business owners like the flexibility and ease of maintenance of an LLC.   Others prefer the checks and balances found in the more structured management of a corporation; or need an S corporation because they want to attract investors in the corporation; or they must form an S corporation because of the nature of their business.  The wrong choice may cost you in time, money and grief, so the decision should not be made without first consulting your attorney and your accountant.  If you are interested in forming or converting[3] your business to an LLC or S corporation, please feel free to contact your attorney to discuss your options.



[1] There are significant differences between “S” corporations (“Small” corporations) and  “C” corporations.  For example, if you will be seeking investors and will have a large number of shareholders, and/or will be offering more than one class of stock, then the corporation would not be eligible for S corporation status. A C corporation is subject to double taxation (i.e. profits are taxed to the corporation, then are taxed again when distributed as income to the shareholders) but the profits of an S corporation are only taxed once as the income is distributed to the shareholders.  Banks and insurance companies and foreign corporations cannot be S corporations

[2] Although members and shareholders are protected from company liabilities, their ownership interests are not protected from personal liabilities.  California law does not permit owner protection against charging orders.   In practice, a successful claimant against an owner personally would be entitled to receive only distributions of company profits, but not voting rights or management rights.  It is uncommon for a judgment debtor to obtain and subsequently enforce a lien against the ownership interest itself.

 [3] If you already have an LLC or S corporation, it is possible to convert to the other type of entity; and it may be to your advantage to do so.

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