Two popular classifications for businesses today are the LLC – Limited Liability Company – and an S-Corporation. Each of these has pros and cons, but which is right for you?
This is an important question and one that requires quite a bit of thought and consideration.
Who Can be an Owner or Member?
If you have chosen an LLC, each of the owners are called “members.” An LLC can have a single member, or several members. Members can be individuals, other LLCs, partnerships, corporations or trusts. An LLC can be managed either directly by the members, or the members may elect to appoint a manager to handle the day-to-day affairs of the LLC
With an S corp, the members or shareholders are limited based on the tax law. According to the law, shareholders can be an individual, or certain estates and trusts. Trusts that have individuals as the beneficiaries can own shares in the S corp. Business trusts cannot be the shareholders. The Internal Revenue Code also restricts the number of owners of an S corp.
What Can be Contributed to Gain Ownership or Membership Interest?
For an LLC, members typically contribute enough cash or other property to pay for the startup expenses and assets.
With an S corp, there are several options. Cash or property contributions are considered the easiest way to do this. Another option is sweat equity, which is when a member offers their services in exchange for an ownership interest in the company.
For tax purposes, the IRS will classify a business as a sole proprietorship, partnership, S corporation or C corporation. Since LLCs are purely a function of state law, there’s no LLC tax classification. This means LLCs are taxed as another business type.
For those with a single member LLC, they will be taxed as if their business was a sole proprietorship. For the multi member LLCs, taxation is identical to partnerships. However, there’s also the option for an LLC to choose to be taxed as an S corporation or a C corporation.
- Single Member LLC Taxation: If your business is considered a single member LLC, then it will be considered a disregarded entity and taxed as a sole proprietorship, all expenses and income are reported on your personal income tax return and you pay personal income tax on all net company profits.
- Single Member LLC as S Corporation: With this tax designation, the owner-employee has to be paid a reasonable salary and the LLC reports the salary as a business expense. The owner reports the salary and remaining business profits on his or her personal tax return.
The S corp is taxed similar to a partnership and considered a pass-through entity. There’s no federal income tax levied on this company at the corporate level. Instead, the profit is allocated to the shareholders and taxed at this level.
Termination and Succession
With an LLC, if there is no operating agreement in place, or if the operating agreement has no information regarding a member’s death, the state law will determine if the members death effects the business and how. In some areas, the LLC may dissolve automatically once a member dies and in other cases, the deceased member’s executor will take over their membership.
When a shareholder of an S corporation dies, their shares will become part of their estate and pass to their beneficiaries. The new owner will step up as the shareholder. The business will continue to function as normal, even as shareholders change. S corp shareholders must be careful, though, to maintain the requirements for S corp status and not allow unauthorized owners.