When you finally launch your venture, will it be an S Corp, a C Corp (doubtful), an LLC, or an LLP? Choosing the legal structure of your start-up is very important and has major ramifications on not only the entrepreneur’s legal liability, but also on personal income and eventual exit. Without incoprorating as one of the above, the owners’ liability is not limited to the assets and money invested in the company, but instead include all of the owners’ personal assets. To avoid that level of exposure, choose one of the above legal structures. Among all the choices, LLCs and S Corps are the most common legal structures for start-ups today, and the discussion below will focus on the differences and similarities in those legal structures.
The major advantage of an S Corp (short for S Corporation, named for the section in the IRS tax code that describes it) is that revenue flows through to the company owners, avoiding double taxation and increasing personal income to the owners. The way it works is that in other legal structures, a company’s revenue is taxed at the corporate income tax rate after it’s netted with the company’s expenses. (That’s an over simplification, but good enough to make the point). Then, the cash that’s left over is available for distribution to owners. The owners are taxed on the distributions from the company at their personal income tax rate if the cash is treated as salary, or at a slightly lower rate if the cash is treated as a dividend. Either way, the revenue is taxed at the corporate level and again at the individual level. In an S Corp, revenue “flows through” the corporate level to the individual level and is only taxed once at the personal level. It shows up on a tax form called a K-1. Because revenue is taxed once, not twice, there’s more cash to going directly into the owners’ pocket, even after paying FICA, SS, and other payroll fees.
The main disadvantage of an S Corp over an LLC is the higher attorney and accountant fees to set up the S Corp. Other hurdles include a legal requirement that the S Corp have elected officers, meetings, minutes for those meetings, less than 100 shareholders, and a proportionate distribution of profits/losses based on ownership interest.
The major advantages of an LLC are the easy and inexpensive setup, there’s less red tape and requirements than an S Corp, and there’s an option to treat revenue like an S Corp for tax purposes. In addition, a single owner LLC doesn’t have to file a corporate tax return. The combination of an LLC’s legal structure and the tax treatment of an S Corp, there’s almost no reason to use any other method of incorporation, especially in a single owner business.
The only disadvantages of an LLC are that a single owner LLC must pay self-employment tax and must be careful to separate personal from professional activities, but those are true for single owner businesses, regardless of the legal structure. Additionally, some investors and creditors may be more comfortable investing in an S Corp than an LLC. An S Corp has requires paperwork, including financial statements, that investors often want to see.
Looking into the future toward your exit is an important factor as well. If you plan to sell the company, it’s better to incorporate as an S Corp or LLC so the sale can be structured as a sale of assets rather than as a sale of equity shares. For mergers or public stock offerings, the company and owners are better off as a C Corp from a tax perspective.