What Is the Difference Between an LLC and an S-Corp?

AdobeStock_386942563-300x131Entrepreneurs of all kinds face a daunting choice when trying to determine whether to establish their businesses as limited liability companies (LLCs) or S Corporations (S-corps). While an LLC will be a separate business structure, an S Corporation is actually a tax status, so forming an LLC involves filing paperwork with the state of California, while an S Corporation will involve filing paperwork with the Internal Revenue Service (IRS).

The decision between LLC and S-Corp status is not an easy one to make, so make sure you have proper legal guidance every step of the way. You will want to work with a San Jose business formation attorney at Structure Law Group, LLP.

Advantages and Disadvantages of LLCs

One advantage LLCs have over S-corps is that businesses will have fewer forms to register, helping reduce your startup costs. Additionally, you will not have to hold formal shareholder meetings and maintain annual minutes for an LLC.

LLCs also provide more flexibility than S-corps because S-corps have pro-rata requirements for income, loss, or distributions, while LLCs can allocate income, loss, and distributions within the parameters of the tax law. You should describe the method of these allocations in your operating agreement, which a San Jose LLC attorney can help prepare.

Another advantage LLCs have over S-corps relates to tax basis, which is what allows taxpayers to deduct business losses and take non-taxable profit distributions. LLC member-owners will receive an increase in their tax basis for their share of qualifying debt in addition to equity.

LLCs do limited lifespans, though, so members will have to decide on the duration of an LLC in advance, usually upon filing with the state. When there are hopes to issue shares to employees or to take a company public, then the LLC could be required to convert to a corporate business structure first.

When LLC members are active in the business, they can also be subject to self-employment tax. This translates to LLC members having to pay a 15.3 percent self-employment tax that includes Social Security and Medicare taxes on their distributive share of the LLC’s net taxable income.

Advantages and Disadvantages of S-Corps

One big difference between an S-Corp and an LLC in California will be the 1.5 percent S-Corp tax and the LLC fee. The 1.5 percent S-Corp tax depends on the California net-taxable income, while an LLC fee depends on California annual gross receipts, so a company typically pays much higher rates under LLC fees.

Being an S-Corp can also provide tax savings to the owners for self-employment tax purposes, whereas an active LLC member could be subject to self-employment taxes on the distributive share of LLC income. S-Corp shareholders will only pay payroll taxes on wages received from the S-Corp as being its shareholder or employee.

Shareholders also receive reasonable compensation from an S-corp. When a shareholder receives a large amount of cash distributions while taking a meager salary, the IRS can challenge their compensation and reclassify the distributions as wages during an examination.

S-corps exist independently from their shareholders, so when one of the shareholders sells their shares or dies, the S-Corp will continue doing business. Because the business will be its own corporate entity, the lines between the business and the shareholders are much clearer and improve protection for shareholders.

However, since S-corps are separate structures, they also require scheduled shareholder and director meetings. You must record minutes at these meetings, and other requirements can include updates to bylaws, adoption, records maintenance, and stock transfers.

Keep in mind that not all states treat S-corps the same. California taxes S-corps at either 1.5 percent of their net income, or $800 (whichever is higher), in addition to the income tax that shareholders must pay on their share of the S-Corp’s income.

Employees and shareholders are also not able to claim tax benefits on the business expenses they incur. Because employees and shareholders are considered employees of the company, any unreimbursed business expense will be unreimbursed employee expenses, only tax-deductible for California income tax purposes subject to 2 percent of adjusted gross income.

Call Us Today to Schedule a Consultation With a San Jose Business Formation Attorney

Are you debating whether your business should be an LLC or an S-Corp? Get helpful legal guidance from a San Jose business formation lawyer at Structure Law Group, LLP on which route will be best for you.

Our firm knows all of the differences and can help outline how provisions relating to each will benefit you personally. You can call (408) 441-7500 in Silicon Valley or (310) 818-7500 in Los Angeles, or contact us online to receive an initial consultation that will allow us to take a lengthier look at your case and be able to recommend the next best steps to take.