S Corp vs. LLC: Which One Should I Form
The question of whether to form an LLC or an S Corp requires a determination both about entity form and about taxation. Make sure you consider both issues carefully.8 min read
“How should I structure my new business – as an LLC or as an S Corp?”
I get that question from time to time from clients who want to start a new business.
But there are really two separate questions embedded there:
Question 1 (State Law Form): Should I form my company under state laws as a “Limited Liability Company” or as a “Corporation”?
Question 2 (Federal Income Taxation): Should my company elect to be taxed under federal income tax laws as a “Partnership” or as an “S Corporation”? (The concept of “S”-vs.-“C”-Corporation is purely a tax distinction.)
To make the right decision about the form of your new business, it’s important to understand and address both questions. The two questions are interrelated – a certain answer to one question may limit the possible answers to the other question, and vice versa.
This article discusses three possible combinations of answers to Question 1 and Question 2. It also notes some pitfalls to be aware of when forming an LLC and electing to be taxed as an S Corporation.
This article assumes that the business is not looking to raise seed money with angel investors, and is not interested in being taxed as a C Corporation. Small businesses that are interested in raising equity financing with angel or VC investors should consider incorporating as a Delaware Corporation and electing (by default) to be taxed as a C Corporation.
Three Possible Combinations
Question 1 is about the form of your new company under the laws of your state of organization. Once you select your state of organization, you can form either a Limited Liability Company (LLC) or a Corporation.
Question 2 is about how the IRS will treat your new company for federal income tax purposes. If you form a multi-member LLC in your state, you can elect with the IRS to be taxed as a “Partnership,” a “C Corporation,” or an “S Corporation.” If you form a Corporation in your state, you can elect with the IRS to be taxed as a “C Corporation” or an “S Corporation.”
Assuming that C Corporation tax status is not on the table, there are three possible combinations of answers to Question 1 and Question 2:
- LLC taxed as a Partnership
- Corporation taxed as an S Corporation
- LLC taxed as an S Corporation
Each option has certain advantages and disadvantages to consider.
LLC Taxed as a Partnership
If you form an LLC with more than one member, your LLC will automatically be treated as a Partnership by the IRS for income tax purposes, unless you make a different election. This means that profits and losses will not be taxed at the entity level, but will “pass through” to the members’ individual tax returns.
Advantages of an LLC taxed as a Partnership
Limited Liability – members of an LLC are not personally liable for the debts of the company. The LLC law in most states provides an additional layer of protection known as a “charging order,” which limits the remedies available to any judgment creditor of any member.
Flexible Management – members of an LLC can decide by agreement how they want to manage the business, and they can avoid or decrease many of the corporate formalities and duties required for Corporations. This means less paperwork and expense, as well as less risk of losing limited liability protection.
Economic Structuring – an LLC taxed as a Partnership can allocate profits and losses and make distributions to the members according to whatever economics the members agree to – allocations and distributions do not have to be made based on capital contributions or ownership percentages. Additionally, members are free to create multiple classes of stock (including profits interests) with different economic profiles.
No Ownership Restrictions – entities and foreign persons are not restricted from being members of an LLC taxed as a Partnership.
Default Tax Rules – because a multi-member LLC will be taxed as a Partnership by default, there is certainty with regard to how the company will be treated for tax purposes. There is no chance that Partnership taxation status would be denied or unavailable.
Disadvantages of an LLC taxed as a Partnership
Disputes can be Unpredictable – it can be difficult to predict how disputes between owners of an LLC will play out, especially if the operating agreement is silent about how to handle a particular dispute.
Self-Employment Taxes – distributions and salary payments to members are generally subject to self-employment taxes. “Splitting” income between distributions and salary payments will generally not reduce a member’s obligation to pay self-employment taxes on all amounts received from the LLC.
Corporation Taxed as an S Corporation
If you form a Corporation under state law, you will be taxed as a C Corporation unless you elect to be taxed as an S Corporation by filing Form 2553 with the IRS within the specified period of time. There are certain organizational requirements that the company must meet to be eligible to be taxed as an S Corporation. In particular, the company must have a single class of stock and have no more than 100 shareholders, all of which must be individuals who are citizens or legal residents of the United States. Taxation of an S Corporation is a “pass through” regime similar to that of Partnerships – profits and losses of the company are passed through to the shareholders.
Advantages of a Corporation Taxed as an S Corporation
Limited Liability – shareholders are not liable for the debts of the company.
Savings from Self-Employment Taxes – shareholders may be able to save on self-employment taxes. A shareholder who receives a salary or wages from the Corporation would only be required to pay the employee’s portion of employment taxes on such amounts, with the company paying the employer’s portion. Additionally, distributions of profits to shareholders would not be subject to self-employment taxes.
Less Unpredictability – outcomes of disputes among shareholders are more predictable.
Disadvantages of a Corporation Taxed as an S Corporation
Restrictions on Ownership and Economics – Corporations electing to be taxed as S Corporations must meet the ownership restrictions noted above (e.g., no more than 100 shareholders). Additionally, only one class of stock is permitted. Allocations of profits and losses and distributions of profits to shareholders must be made pro rata in accordance with percentage ownership.
Corporate Formalities – there is much less flexibility in managing a Corporation.
Tax Uncertainty – the IRS looks closely at S Corporations. In particular, the IRS will closely review any income “splitting” arrangements that split a shareholder’s payments into salary and dividend components. The IRS may disallow a splitting arrangement if it deems it to be unreasonable. Additionally, there is risk that the IRS could deny or reject a company’s election to be taxed as an S Corporation. If a Corporation’s S-election is rejected, the Corporation will automatically be subject to C Corporation taxation.
LLC Taxed as an S Corporation
An LLC can elect to be taxed as an S Corporation by filing a Form 2553 with the IRS within the specified period of time, provided that the LLC meets the requirements for S Corporation status noted above (e.g., no more than 100 individual shareholders; single class of stock). If an S-election is not timely made or is denied or rejected by the IRS, the LLC would be taxed as a Partnership (or as a disregarded sole proprietorship in the case of single member LLC).
Advantages of an LLC taxed as an S Corporation
Limited Liability and Flexible Management – same as above for LLCs taxed as Partnerships.
Savings from Self-Employment Taxes – as with a Corporation taxed as an S Corporation, members of an LLC taxed as an S Corporation can “split” their payments from the LLC into distributions and salary/wages. Salary payments (usually called “guaranteed payments” in the LLC operating agreement) would be subject to employment taxes (with the member paying only the employee’s portion and the LLC paying the employer’s portion). Distributions of profits would not be subject to self-employment tax.
Disadvantages of an LLC taxed as an S Corporation
Disputes can be Unpredictable – same as above for LLCs taxed as Partnerships.
Restrictions on Ownership and Economics – same as above for Corporations taxed as S Corporations.
Tax Uncertainties – the tax risks and uncertainties facing an LLC taxed as an S Corporation are potentially greater than those of a Corporation taxed as an S Corporation. Part of the reason for that is that most LLC operating agreements are based on the idea that LLCs have flexible economics and are normally subject to Partnership taxation. This means that standard LLC operating agreements are not suitable for an LLC electing to be taxed as an S Corporation. Many of the terms of a standard operating agreement could threaten the LLC’s S-election by causing the LLC to be deemed to have multiple classes of stock. Furthermore, if the IRS denies or rejects an S-election by an LLC, the LLC would default back to being taxed as a Partnership. This can be very costly if the LLC and its members have taken certain tax positions suitable only for S Corporations (e.g., splitting income and not paying self-employment taxes on distributions).
Potential Pitfalls for an LLC Taxed as an S Corporation
In one respect, forming an LLC and electing to be taxed as an S Corporation may seem like the “best of both worlds” – you get the management flexibility (and asset protection) of the LLC form under state law, but you can also potentially save money by avoiding self-employment tax obligations. However, there are potential pitfalls with taking this approach. If you go this route, make sure you consult a tax adviser and make sure your hire an attorney that can help you navigate the potential pitfalls.
At the very least, you should make sure that your LLC’s operating agreement is suitable and specifically tailored for an entity electing to be taxed as an S Corporation. This is often overlooked. However, failure to properly tailor your operating agreement could result in the loss of your S Corporation status as well as tax penalties. The costs of such an outcome could be significant.
As an example, here are some of the items that should be revised and tailored in a standard LLC operating agreement to allow for the LLC to make an S-election:
- Capital Accounts – reference to capital accounts should be eliminated, or a provision should be added stating that capital accounts will have no effect on allocations or distributions.
- Allocations and Distributions – revisions should be made to make clear that all allocations of profits and losses, and all distributions (operating and liquidating distributions) will be made pro rata based on ownership percentage. It’s particularly important to make sure that the liquidation provisions do not provide a back door to distributions based on something other than ownership percentage. If these revisions are not made, the LLC could be deemed to have multiple classes of stock, which would disqualify it for S Corporation taxation.
- Guaranteed Payments – consider adding a section on “guaranteed payments” providing that the company may determine and pay guaranteed payments to some or all of the members as consideration for services rendered to the LLC. Guaranteed payments are essentially treated like salary payments – they are expenses of the company that are paid out regardless of profits.
- Transfer Restrictions – consider adding transfer restrictions that would disallow or void any transfers of membership interests that would cause the company to fail to meet the S Corporation requirements. Similar restrictions could be put in place for issuances of new membership interests.
- Reference to Partnership Taxation Rules – references to the Code that relate to Partnership taxation concepts should be revised or removed with assistance from attorneys and tax advisors.
This list is not complete. Make sure your attorney has expertise in S Corporation matters and has fully vetted your operating agreement before you make an S-election. Always consult with a tax advisor before making any kind of tax election.
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