What’s the difference between an S Corporation and LLC?
When setting up a business structure with partners, which business entity should I form and what are the pros and cons of each?
In this article we will discuss the typical business formations you see in the United States. We will discuss which business entity is best for you and the pros and cons of each.
These business structures can provide you, your family, and your business both tax benefits and protection from legal issues.
To set one up, you need to check nationwide secretary of state searches, for business and corporation entity name availablity.
Note: Choose your entity carefully. Setting up the wrong business structure for your business can cost you in many ways: taxes, regulatory restrictions, legal, and finance (stock) considerations are among a few. Give the design and structure of your business as much thought and consideration as you did your initial preparations.
The Different Business Structures
- Sole Proprietor
- Limited Liability Companies (LLC)
- The New Series LLC
- Living Trusts
This is the most basic business structure form as is not considered a business entity.
It basically entails you getting a business license in your state, getting a bank account, and setting up shop. One person described it to me as you against the world. I highly DO NOT recommend this business structure for you. It provides you with no legal protection from others, limited financial options, and the least tax savings strategies.
So why do people not incorporate? Usually two reasons:
- They have no money and this is a cheap method to start a business
- They don’t know anything about business structures
Pros and Cons – Sole Proprietor
People look to form partnerships when there are two or more individuals looking to start a for-profit, unincorporated business and are all part owners of it.
There are two basic types of partners – general and limited.
General partners assume all responsibilities as owners and managers whereas the limited partners are limited in their liability to the amount he or she invested in the business. Like sole proprietor, a partnership structured business is viewed as being one and the same as its owners.
This is probably the most used partnership form and is the easiest to set up. All partners manage the business equally and are all personally liable for its debts. There is very little liability protection.
Limited Partnership – (LP)
This form of partnership consists of a general partner(s) and a limited partner(s). The general partner operates much the same as in general partnerships and basically “runs” the business. The limited partner is limited only to what they invested in the business and typically do not “run” the business. In other words, they are only responsible for those debts they contributed to the business.
Limited Liability Partnership – (LLP)
Much the same as a LP but is organized so that all partners have some degree of liability in the company.
Family Limited Partnership – (FLP)
A FLP is a partnership composing of both general and limited partners and is a great business structure for protecting family assets (especially when used in conjunction with other business structures and set up properly) and transfer of property.
As the name suggests, it works well when dealing with family, however, in reality it’s just a simple LP. The name really is only given to it to refer that the partnership deals with family assets. When we file FLPs, we are really filing a LP.
Typically the general partners would be parents or grandparents who want to pass down assets to their heirs when they pass away. The children would be the limited partners.
Pros and Cons – Partnerships
First let’s start with what a corporation is and where the best place to incorporate in will be (and why). Then we’ll move on to the different types of corporations.
Corporations are considered legal entities all on their own, separate from the business owner, and are formed and licensed in the state they operate in.
You can think of a corporation kind of like a person all on their own. They have to file taxes, can own property and assets, buy and sell assets, raise money, buy a benefits package for its family (the employees), etc.
Because of this separation of owner and business, a corporation provides what is called a corporate veil. This means you and your personal assets, money, etc. are all protected from law suits and are separate from your business.
You may hear the term “Pierce the corporate veil.” This refers to the scenario when someone may want to sue you, for example, and not just your company. But since you’re incorporated and were acting as an employee of your business, however, you have that layer of protection since this person technically can only sue your business and whatever assets it holds.
State laws vary as to how well the corporate veil is protected. This is one big reason why the two most popular states to incorporate in are Delaware and Nevada. Of the two, Nevada is the best. Nevada provides the best layer of protection for business. Basically, the only way for someone to pierce your company’s corporate veil is if you commit fraud.
Nevada Corporations are Attractive Because
- Nevada has no franchise tax
- no corporate income tax
- no personal income tax
- does not have information sharing agreements with the Internal Revenue Service
- Nevada strongly protects the business owner
If you are starting or have started a business that doesn’t deal much in other states, make a lot of money, and your liability is relatively low, then you may simply just want to incorporate in your own state. If, however, you plan to do business country-wide or world-wide and protecting your assets is essential, consider incorporating in the State of Nevada.
A note about taxes…
If you’re going to set up a business structure in a state other than the one you do business in, for example you live and work in California but incorporate in Nevada, you will still have to pay taxes on your income according to California tax laws.
How incorporating in Nevada but doing business elsewhere works
First you would incorporate your business in the State of Nevada. Nevada now becomes your domicile (your business’ residence). Then register your new corporation in your state of business (called foreign filling).
Types of Corporations
- C Corporations
- S Corporations
- Professional Corporations
- Non-Profit Corporations
The basics of what corporations are is described just above this subheading.
A C Corp is completely separate from the business owner. It pays its own taxes, pays you your salary, and then you pay your taxes. In other words, the business’ income does not pass through to your personal income tax reporting’s.
This can lead to what is referred to as double taxation (your company pays taxes and so do you on some or all of your company’s taxable income). While this may seem unfavorable, C Corps provide the widest range of tools to expand your business.
For example, you can have unlimited shareholders so you can raise as much money as you want. Also, C Corps are taxed differently: for the first $50,000 of taxable income, your business would only pay a tax rate of 15% (when a S-Corp pays at the standard rate).
C corps are a good design for companies that make and deal with a lot of money, have many employees and/or shareholders, have little or no chance of making a loss, and if expansion is likely.
Pros and Cons – C Corporations
S Corporations are basically corporations that have elected to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.
The two main points you should know about when it comes to the difference between a C Corp and S Corp is how they are taxed and how many shareholders you can have. There are, of course, other differences; but this article is about giving you the condensed necessary information needed to approach and speak with a professional.
As far as taxes go, S Corps don’t pay their own taxes like C Corps do (thus eliminating the double taxation problem). Instead, the taxable income is passed through to the shareholders (the owners).
In other words, if your company made $100,000 taxable income, you would show that income on your personal tax return (whereas a C Corp would first pay taxes on that $100,000 and then pay you your income and you would pay taxes on that income as well).
This form of pass-through taxation is especially favorable if you expect your company to make a loss for the taxable year. In this way, if your company paid more money out than what it made, those losses would pass through to your personal income taxes and can be written off as deductions (whereas if a C Corp had a loss, those losses would not pass through to your personal income tax).
There is one really nice feature of corporations I’d like to mention (both C and S).
As a corporation, you must conduct an annual board of director’s meeting to discuss your business. They can even be done more often than once per year. The best part is, this meeting and all expenses incurred because of it is tax deductible (and it can be held anywhere in the world).
Therefore, many small business owners schedule this meeting around family vacations. By doing this, their plane ticket, gas, food, etc. can all be written off on their taxes. If by chance you decide to go to Disneyland or some other from of entertainment, you can only write a portion of that off . . . but hey, that’s better than nothing.
Pros and Cons – S Corporations
Businesses that require a license to practice must be formed as a professional corporation.
For example, the following professionals would have to form a professional corporation: dentists, veterinarians, CPAs, lawyers, doctors, chiropractors, etc. By forming a professional corporation, professionals can limit their personal liability for the malpractice of their associates.
One downside to a professional corporation is that they are taxed a little differently than regular corporations . . . and not necessarily in a good way.
Non-profit corporations are exempt from income tax. Such businesses may include: charitable, educational, religious, scientific, or literary organizations. If you wish to form a non-profit corporation, you may want to briefly review Section 501(c) (3) of the Internal Revenue Service Code. These kind of corporations also need to be owned by more than one person and any excess funds (funds remaining after donations have paid for all expenses) must go toward the growth and expansion of business and services.
The LLC business structure has become one of the most favorable business structures around, especially in real estate.
It combines most of the advantages of other business structures while limiting their disadvantages. They work much like S Corps; pass-through taxation, provide liability protection and asset protection for owners, require board meetings, business debts do not show up on personal credit, etc.
There is one big difference between the S Corporation and a LLC which makes the LLC structure advantageous.
The following is probably the BEST example of why you need to take some time and think about what business structure is for you and your business.
In an S Corp, if there are 2 owners then income must be allocated to owners according to their ownership interests. In other words, if John and Bob formed an S Corp, they could structure it so John owns 50% of the business and Bob owns 50% of the business.
If, however, John performed 90% of the work over the year and Bob sat at home and did nothing, Bob would still earn the same amount of money as John (or is suppose to by law).
If instead they formed a LLC instead of an S Corp, then profit and losses can be allocated differently than ownership interests. Therefore, John could earn 90% of the income and leave Bob with the remaining 10% even though Bob owns 50% of the business.
You should consider this business structure using the same reasons to consider an S Corp except you should take into account whether or not you want to have control over who earns what profit regardless of ownership in the business.
Also, if you own real estate you may want to become familiar with LLCs.
For example, if you owned 5 rental properties and you had no liability protection and one of your tenants hurts themselves on your property, they could sue you. Everything you own could be attached to the judgment. If, however, you placed each of your 5 rental properties in its own LLC then that person could only sue the LLC that owned the property they got hurt on; all your other assets and rentals are insulated from this lawsuit.
Pros and Cons – Limited Liability Company (LLC)
This is a new business structure which has yet to be fully tested in the courts and may not be recognized by all 50 states. It was designed primarily for real estate investments.
Normally, a real estate investor would set up a separate LLC for each house / rental property they own so that they are protected liability and asset-wise. This can be a huge headache, become expensive, involve lots of paperwork, and create a tax nightmare.
Using the new Series LLC structure, a real estate investor could place all their investment properties under one LLC which stipulates each property is sheltered from the other. Therefore, if someone hurt themselves on property A, they could not attach a judgment to property B (or anything else).
Also, the real estate investor could save a lot of time and money by only filing one tax return.
A living trust is a legal entity but not quite the same as corporations. You can think of a living trust much like a will. It is a document you place instructions in to pass along your assets after you die. You can also mention certain instructions you wish to happen if you were to become comatose or living solely on life support.
A trust can own things just as a corporation can. It can own real estate, cars, jewelry, clothing, etc. Individuals with a lot of assets and/or equity typically look to form living trusts as an added layer of asset protection. Unlike a corporation though, trusts do not pay taxes (in your lifetime). Any profits or losses are passed through to the individual’s personal income tax.
Living Trusts have one huge advantage over a will. Because a living trust is privatized, it remains out of the courts and thus avoids the possibility of going to probate court if there are any issues that arise when the owner of the trust passes on.
What A Trust Consists Of
A trust consists of the following:
- Grantor – owner of the trust
- Trustee – the person who executes the instructions in the trust after the Grantor dies
- Beneficiaries – the one(s) who receive items/equity from the trust
If you own a business or want to set up a business structure for asset protection, simply contact our partner, BizFilings to get set up. I hope you can see by reading our articles that we know a thing or two about succeeding in business and knowing which companies can help you achieve success.