LLC vs. S Corp: which is best for startups?

The basic structure of an LLC and an S Corporation

How does an LLC work?

To form an LLC, you must file an Article of Organization with the state in which the business will operate.

An LLC is a business entity that is separate by law from its owners, who are called “members.” This legal separation provides personal asset protection. In other words, if the company has debt or liabilities, the members’ personal assets are protected from business liabilities.

As far as members, LLCs can have a single or multiple members, each owning a percentage of the LLC. Members can be individuals, corporations, other LLCs, or foreign entities. Further, there's no limit to the number of members an LLC can have, providing flexibility for how the LLC is arranged.

As for taxes:

LLCs are typically taxed as pass-through entities. What that means is that the business doesn't pay taxes on its income; instead, the business’ profits and losses are transferred to the individual members who report their share on their personal tax returns.

How does an S Corporation work?

An S Corporation is formed as a regular corporation and then electing S Corp status with the Internal Revenue Service (IRS). (You must file Form 255312).

Shareholders must be individuals, certain trusts and estates, or specific tax-exempt organizations. There can be no more than 100 shareholders. Partnerships, LLCs, and corporations cannot be shareholders.

An S Corp provides limited liability protection for its shareholders, meaning the shareholders' personal assets are generally protected from the company's debts and liabilities.

There are exceptions, though. When a shareholder personally commits a tort or engages in negligent behavior, they can be held personally liable for resulting damages.

Regarding taxes: 

The corporation itself does not pay federal income tax. What happens instead is that the S Corp’s income, losses, deductions, and credits are transferred to its shareholders. They report their share of these items on their personal tax returns and pay taxes at their individual income tax rates.

What are the main differences between an LLC and an S Corporation?

Formation

Typically, LLCs are easier to form and maintain than S Corporations. 

Why? That’s because LLCs allow for more flexibility, specifically for its management structure and profit distribution. 

S Corporations, on the other hand, have stricter requirements and formalities to follow.

Ownership

There are generally no restrictions on ownership for LLCs. In other words, LLCs can have an unlimited number of members. Members can be individuals, corporations, or other LLCs.

S Corporations have ownership rules that are more stringent. As mentioned earlier, they are limited to 100 shareholders. 

Shareholders must be U.S. citizens or residents. Different from LLCs, however, S Corporations cannot be owned by other corporations, partnerships, or non-resident aliens.

Taxation

LLCs are typically taxed as pass-through entities by default, meaning the business itself doesn't pay taxes. 

Instead, the LLC’s profits and losses are transferred directly to the owners' personal tax returns. 

Having said that, LLCs can choose their tax treatment, including being taxed as a corporation if desired.

As far as self-employment taxes, in most cases, all of an LLC member's share of profits is subject to self-employment taxes. 

S Corporations are also pass-through entities for tax purposes. 

However, S Corps have a unique tax advantage — shareholders who work for the company can receive both a salary and distributions. 

Now, what makes this unique is that only the salary counts for self-employment taxes, which may affect overall tax liability. It’s important to note that the IRS requires that shareholders receive a "reasonable salary" for their work.

Management structure

LLCs offer flexibility in management structure. They can be member-managed (where all owners participate in its management) or manager-managed (where designated managers run the company).

S Corporations, on the other hand, require a more formal management structure, with an official board of directors overseeing major decisions and officers managing the company’s daily operations.

Profit distribution

A key difference is that LLCs have flexibility in how they distribute profits among members. This distribution doesn't have to be proportional to ownership percentages. For example, distribution can be based on the percentage each owns or they can be tied to each owners’ performance results.

S Corporations must distribute profits to shareholders based on their ownership percentages.

LLC vs. S Corp’s compliance and formality

The exact requirements of an LLC versus an S Corp can vary by state. It’s a wise move to consult with a legal or tax professional to ensure full compliance. 

So, what’s the difference between an LLC and an S Corp’s compliance and formality?

Well, LLCs have fewer formal requirements and offer more flexibility in management and record-keeping. The level of formality can often be determined by the members and outlined in the Operating Agreement, if the LLC decides to create one.

An S Corporation requires more rigorous adherence to corporate formalities, including regular shareholder meetings, detailed record-keeping, and strict compliance with bylaws and state corporation laws.

When to choose an LLC vs. S Corporation

The choice often depends on specific business circumstances, goals, and preferences. 

Let’s review simple scenarios where one might be better than the other.

Scenario 1: Simple startup

You're starting a small business with a friend and want a simple structure with minimal paperwork. 

In this scenario, an LLC might be more attractive as LLCs offer flexibility and simplicity in management and operations, with fewer formal requirements than S Corporations. 

Generally, LLCs are often better for smaller businesses, while S Corporations can be advantageous for larger or growing businesses.

Scenario 2: Startup that eventually wants to go public

Now, let’s stick with the startup example from scenario 1. 

Let’s say that your goal is for your startup to eventually go public. In this case, an S Corporation may be more advantageous. 

Why? 

While S Corporations can't go public, the corporate structure may facilitate the transition to a C Corporation when the time is right.

Scenario 3: Foreign ownership

Let’s say that you have non-U.S. citizens or residents who are co-owners of your business. Unlike S Corporations, LLCs don't have restrictions on the nationality or residency of owners, so choosing an LLC would make more sense in this scenario. 

Scenario 4: Attracting outside investors

For this scenario, let’s pretend you're planning to seek outside investment and want a structure that's familiar to investors. 

In this case, the corporate structure of an S Corporation, with its clearly defined shares, can be more attractive to certain investors.

Advantages and disadvantages of LLCs and S Corporations for startups

Converting an LLC to an S Corp 

Converting an LLC to an S Corp is a common trajectory for growing businesses that want to optimize their tax structure and prepare for future growth. 

Let’s review possible reasons for converting an LLC to an S Corp.

• Tax savings: S Corps can potentially reduce self-employment taxes by allowing owners to receive both a salary and distributions.
• Attracting investors: The corporate structure of an S Corp may be more attractive to certain investors.
• Preparing for growth: S Corps can be better suited for businesses that are planning significant expansion or to eventually go public.
• Stock options: S Corps can offer stock options, which can be a valuable tool to attract and retain employees.
• Clear ownership structure: S Corps have a more defined ownership structure through shares, which can simplify transfers and valuations.

Now, let’s review the steps for converting an LLC to an S Corp. 

The conversion process can be complex and may have significant tax implications, depending on your state's laws and your specific circumstances. To formally make the transition, consult with a qualified attorney and tax professional to guide you through the ins and outs of this process.

Steps for converting an LLC to an S Corp

• Check eligibility: Does your business meet S Corporation requirements (e.g., 100 or fewer shareholders, all U.S. citizens or residents)?
• Get LLC member approval: Obtain approval from the LLC members to convert to an S Corporation. This usually requires a majority vote, but check your Operating Agreement for the specific requirements.
• File articles of incorporation: File the essential business formation documents for compliance with your state to create a corporation. This step effectively creates a new legal entity.
• Obtain an EIN: If your EIN was tied to your LLC, you'll need to apply for a new one for your corporation.
• File Form 8832: File this form with the IRS to elect to be taxed as a corporation. This step is necessary because the IRS views LLCs as partnerships by default.
• File Form 2553: Submit this form to the IRS to elect S Corporation status. This must be done “no more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year preceding the tax year it is to take effect,” according to the IRS’ instruction for Form 2553.
• Transfer the LLC’s assets: Formally transfer all assets and liabilities from the LLC to the new S Corporation.
• Issue stock: Issue stock to the shareholders based on their ownership percentages in the former LLC.
• Update contracts and accounts: Notify all relevant parties (banks, vendors, customers) of the change in business structure. Update contracts accordingly.
• Establish corporate bylaws: Create and adopt corporate bylaws that outline the governance structure of your new S Corporation.
• Hold a kickoff board meeting: Conduct a board of directors meeting to establish corporate formalities.
• Maintain corporate formalities: Begin following S Corporation requirements, such as holding regular board meetings, maintaining detailed records, and following stricter accounting practices.

Remember, while converting to an S Corp can offer benefits, it also comes with increased administrative responsibilities and formalities. Carefully consider whether these align with your business goals and capabilities before proceeding with the conversion.

What options besides LLC and S Corp are there?

In addition to LLCs and S Corporations, there are several other business entity options available to entrepreneurs. 

Here's a high-level overview of some common alternatives, including C Corporations and Sole Proprietorships:

C Corporations

C Corporations are traditional corporations that are taxed separately from their owners. They offer limited liability protection to its shareholders and have no restrictions on ownership. There is no limit on the number or type of shareholders.

A clear disadvantage to C Corporations is that profits are taxed at the corporate level and then they are taxed again when distributed to its shareholders as dividends.

An advantage, though, is the ability to raise capital through stock sales, which may appeal to investors and even potential employees who can get stock options.

Sole Proprietorships

A Sole Proprietorship is a very simple business structure, and there's no legal distinction between the owner and the business. Note that it doesn’t offer legal protection for the owner.

Forming a Sole Proprietorship is fairly simple and cost-effective. What’s more, the owner has direct control of it. 

As far as taxes, it is taxed as a pass-through entity—the business’ income is reported on the owner's personal tax return.

General Partnerships

A General Partnership is a business structure where two or more individuals or entities jointly own and operate a business. All partners in a General Partnership share the management, profits, and losses of the business equally, unless otherwise specified in a partnership agreement. 

So, each partner in a General Partnership is personally responsible for the debts and requirements. This means that personal assets can be at risk if the business has debts or faces legal issues.

A General Partnership is taxed as a pass-through entity. 

While General Partnerships offer simplicity and flexibility to structure their business operations and profit-sharing, they also come with significant risks due to the shared liability. 

What businesses choose to be General Partnerships? 

General Partnerships are a common business structure used by various types of businesses, particularly small businesses involving two or more individuals working together.

Limited Partnerships (LPs)

LPs are a specialized form of partnership that combines elements of general partnerships and limited liability entities. LPs have two types of partners: general partners and limited partners. 

LPs are typically taxed as pass-through entities. 

Now, what are the roles and responsibilities of each of these partners? 

Well, general partners are responsible for managing the business and making decisions. Limited partners are investors who contribute capital but don't participate in management.

In terms of liability protection, general partners have unlimited liability for the partnership's debts and obligations. Limited partners' liability, on the other hand, is restricted to their investment in the partnership. 

LPs are often used in real estate investments, venture capital and private equity funds, family businesses, and professional services (in some jurisdictions).

Limited Liability Partnerships (LLPs)

In LLPs, all partners have limited personal liability for the debts and responsibilities of the partnership. In other words, partners are generally not personally responsible for the negligence, wrongdoing, or misconduct of other partners. 

This type of business structure is common for professional service firms (e.g., law firms, accounting firms, consulting firms, engineering companies, architecture firms, and medical practices). It’s particularly suitable for licensed professionals who want to work together while maintaining individual autonomy.

Note that not all states allow LLPs, and some restrict them only to certain professions. Also, in some jurisdictions, LLPs may face higher tax rates or fees compared to other business structures.

Professional Corporations (PCs)

PCs, also known as Professional Service Corporations in some jurisdictions, are a specialized type of corporation designed for licensed professionals. PCs are typically available for doctors and other healthcare providers, lawyers, lawyers, accountants, architects, engineers, and psychologists.

PCs offer personal asset protection for shareholders against the corporation's debts and obligations. But, PCs do not protect against personal malpractice or negligence.

In terms of taxation, PCs can be taxed as a C Corporation or elect S Corporation status for pass-through taxation, which may offer more flexibility in terms of tax planning compared to other structures.

Takeaway: What’s the best choice, an LLC or an S Corp?

Each of these business structures has its own advantages and disadvantages, specifically in terms of liability protection, taxation, management structure, and operational flexibility. The choice of entity depends on various factors, including the nature of the business, number of owners, liability concerns, and tax considerations.

Remember, the rules and the availability of these entity types can vary by state. And, some industries may have restrictions on the types of entities they can form. So, make sure you consult with legal and tax professionals who can guide you on the most appropriate business structure for your specific situation.

For startups, the choice between an LLC and an S Corporation often depends on specific circumstances and long-term goals. LLCs offer more flexibility and simplicity, which can be beneficial for early-stage startups with limited resources. LLCs allow for easy management and decision-making processes, which can be crucial in the fast-paced startup environment.

On the other hand, S Corporations may be more attractive to startups planning to seek significant outside investment or considering going public in the future. The corporate structure and ability to issue stock can make it easier to draw investors and potentially transition to a C Corporation later on.

It's worth noting that good corporate governance practices may benefit both LLCs and S Corporations, particularly as they grow by potentially supporting sustainability and competitiveness.

Wrap up

Ultimately, the decision on whether a startup should be formed as an LLC or an S Corp should be based on the startup's specific needs, growth plans, and the preferences of its founders. Getting legal and financial counsel from professionals is a wise move to make the best choice for your particular startup's situation.

Isabel Peña Alfaro is a guest contributor. The views expressed are hers and do not necessarily reflect the views of Rho.

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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.