LLC vs. S Corporation: “What’s the Difference?”

August 15, 2022by Brandon Banks

According to the National Association of Small Business, LLCs and S-corporations are two of the most popular legal structures for small businesses, accounting for nearly two-thirds of small businesses started every year, in roughly the same proportion (35% and 33%, respectively). The choice between the two structures is highly dependent on the future goals for the business and can be a bit nuanced. The final choice will  have significant consequences for the business and its owners.

Decisions about the legal business structure are best made after careful consideration of the priorities of the founder(s) for ownership rights, management flexibility, the personal liability of the owners, tax treatments of profits and losses, financing flexibility, and ease of formation.

This article intends to provide an overview of two popular structures for new small businesses. The information typically found on the Internet can simultaneously over-simplify the issues or make each seem complicated and intimidating. Starting a business is one of the most consequential decisions made in a lifetime. If you have questions or doubts about what is best for you, consult a licensed business attorney in your State for help. It may be the best investment you will ever make.

Ease of Formation and Ownership

LLCs and S-corps are both created under state laws and must comply with state requirements. While similar from state to state, there are variations in requirements and regulations. The two structures share specific characteristics but differ in others. For example, an LLC is a legal entity, while an S-corporation is a tax election status. Owners of an LLC are referred to as “members” while owners of an S-corporation are “shareholders”.

Creating an LLC or an S-corporation requires filing certain documents in the State of domicile, the designation of a registered agent, and payments of applicable fees. LLC filings include copies of its Article of Organization and Operating Agreement according to the regulations of the State. S-corporation filings include its Articles of Corporation, Bylaws, and the names of Directors and corporate officers. Founders must also file Form 2553 with the IRS to receive Subchapter S corporate status with pass-through taxation.

In most states, LLCs are the least cumbersome to set up and manage since many do not require the filing of an Operating Agreement. An LLC is particularly suited for a single-owner or family partnership seeking management flexibility and minimal documentation and filings.

An S-corporation begins as a C-corporation whose shareholders make an IRS election to qualify for S-corporation status. They are more expensive to establish and manage but offer greater flexibility in future financings. Owners of larger, more complex businesses or anticipating a need for future rounds of equity investment and a future public offering are generally better served with the S-corporation structure.

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Management Flexibility

The Operating Agreement of an LLC defines the party with management responsibility, either a single member, a set of members, or an independent third-party reporting to the members. A separate management agreement between the designated manager and the LLC outlines the duties and rights of the managers.

S-corporations are managed as C-corporations with shareholders electing a Board of Directors. The latter appoints corporate officers to run the business. The duties and responsibilities of the Board and officers are a combination of statutory regulations, corporate bylaws, and Board decisions.

LLCs are particularly popular with single owners or small partnerships seeking maximum flexibility as they are known for their lack of formality. Conversely, S-corporations must have formal shareholder meetings, file annual reports, and keep significant records.

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Owner Personal Liability

Business owners establish an LLC or corporation to limit their exposure to business debts, liabilities, negligence, or acts by the business or other owners. While each owner’s investment in the company remains at risk, other personal assets are typically immune from creditors or plaintiffs. Sole proprietors and partnerships lack similar legal protection.

For example, if a customer sues after slipping on a wet floor of a restaurant owned by a sole proprietor or partnership, other assets of the owner or partners – house, savings accounts, investments – are in jeopardy. A business organized as an LLC or S-corporation eliminates that risk.

State laws regarding personal liability for business owners vary. Before deciding the best structure for a specific business, seeking competent counsel from a licensed attorney in the State of operation is always appropriate.

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Tax Treatment of Profits and Losses

Business owners typically elect to organize to minimize taxes where possible, especially the possibility of being taxed twice on the same income. Shareholders in public corporations are regularly subject to double taxation, paying first on the profits of the business and again on dividends to shareholders.

Many companies experience startup losses in their first years of operations. In C-corporations, the losses are accumulated and carried over to offset future profits of the business. An LLC or S-corporation distributes the business losses to the individual members and shareholders and can be used to offset other personal income.

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Financing Flexibility

When selecting the business structure of a new company, founders need to consider the sources and amounts of the funds required to reach positive cash flow successfully. A second consideration is a possibility of needing additional funds as the business grows. The two structures – LLCs and S-corporations – have requirements that can impede future fundraising.

Neither LLCs nor S-corporations are best suited to operations expected to have more than 100 members or shareholders. Though debt financing is possible in either structure, many lenders typically require a lien on the business’s tangible assets and personal guarantees by members or shareholders. The latter exposes the guarantors’ assets.

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