Comparing Sub S Corporations and LLCS
One of the most frequent questions we get from aspiring entrepreneurs and professionals starting their company is: “what is the difference between a Subchapter S Corporation and a Limited Liability Company?” The short answer for many is: “not much.” Nonetheless, there are important distinctions between the two entities, and some of those are explored below.
The Legal Landscape. Generally speaking, legal entities fall into four categories:
1. Sole Proprietorship
2. Partnership/Limited Liability Company (LLC)
3. Regular (Subchapter C) Corporation
4. Subchapter S Corporation (Sub S)
Most start-up entrepreneurs fully understand the implications of a Sole Proprietorship, and are not yet at the stage of their business cycle to seriously consider a Subchapter C Corporation. For most small and mid-size companies, the entity choice is between the LLC and the “Sub S.”
Formation. An LLC is easier to form than a Subchapter S Corporation. The State of Michigan merely requires submission of properly prepared Articles of Organization, a qualifying name, and the filing fee. Most other states have similar minimal requirements.
A Subchapter S Corporation is not difficult to form, but requires a bit more effort than the LLC. The person organizing the Sub S must meet customary requirements for filing at the state level, and must also timely file a Sub S Election with the Internal Revenue Service.
Ownership. Just about anyone or any number of owners can own an LLC. Under Michigan law, the only potential exceptions are some foreign entities and persons. Federal law poses some restrictions on LLC ownership by Subchapter S Corporations.
To qualify as a Sub S Corporation, the entity must meet all of the following requirements:
- Not be an ineligible corporation (e.g., an insurance company)
- Have no more than 100 shareholders
- All shareholders must be individuals, estates, qualifying trusts or tax-exempt entities
- No nonresident alien owners
- Only one class of stock is allowed (although differing voting rights are permitted)
There is no need to hit this one too hard. These constraints are fairly easy for most start-ups to meet. Nonetheless, the edge still goes to the LLC, which doesn’t impose as many ownership limitations or requirements.
Limited Liability. The LLC and Sub S Corporation afford their owners comprehensive protection from personal liability for the entity’s debts and liabilities. This protection does not extend to debts owners have personally signed or guaranteed, liabilities caused by their distinct personal activities, and in rare cases where the entity may be “pierced” due to certain defects or misuse of the entity.
Some courts (notably the Florida Supreme Court) have deviated ever so slightly from the “no liability” principle, particularly with respect to single owner LLC’s. So far, however, this legal trend has presented no significant threat to honest entrepreneurs who are operating their companies within the “rules.” This factor is a draw.
Management and Administration. The LLC was originated by state governments to avoid many of the administrative pitfalls associated with corporations (Subchapter S or C). As a result, the LLC is less burdensome to manage on a day-to-day or annual basis. There are fewer profit-sharing restrictions, fewer reporting requirements and not as much paperwork required to maintain the entity form.
Salary and Benefits. Salary payments to stockholders who work for the Sub S are deductible by the corporation. The shareholder-employee will pay the customary employment and income taxes on that income. For the most part, the same is true for LLC owner-employees. The Subchapter S Corporation, however, must comply with various rules and restrictions or risk losing these benefits. It is not that difficult to comply with these statutory requirements, but the imposition of such rules gives a slight edge to the LLC.
Advantage: LLC (slight)
Taxation. The basic principle is that neither the Sub S Corporation nor LLC is taxable at the entity level. They are regarded as “pass through entities;” company income is allocated to the owners, whether that income is distributed to them or not. There are some exceptions to this rule for the Sub S corporations. For most, this factor is a draw.
Distributions. The concept of company distributions to the owners is where this choice can get interesting (and complex). The Sub S stockholder enjoys an enhanced opportunity to treat some of his or her compensation as a dividend, subject to the IRS rules on reasonable compensation.
LLC members, on the other hand, may include their share of the company’s debt in their LLC basis. This enables LLC members to deduct a greater level of losses, a feature which is particularly useful for real estate companies. A Sub S shareholder does not enjoy this advantage.
Business owners actually have the opportunity to potentially capture the best of both worlds by forming their company as an LLC, but then electing to be taxed as a Subchapter S Corporation. The owner need only file IRS Form 2553 to be taxed in this manner. As always, the best advice is to consult with us and/or your accountant before making this election. Since many owners prefer the lower tax rates from dividend treatment over the company debt treatment noted above, this choice could prove most beneficial.
Since we live in a complicated world, one other point should be raised. The Federal government frequently sets its sights on Subchapter S Corporations as a means for enhancing its revenue, by, you guessed it, removing dividend tax treatment. This hasn’t happened yet, but that doesn’t mean it won’t. If you are concerned about this potential development but want to retain the Subchapter S tax advantage, the LLC-Sub S combination is the way to go.
Advantage: Subchapter S Corporation (or LLC filing as a Sub S)
Subsidiaries and Affiliates. The LLC can freely own other companies and subsidiaries in whole or part. Subchapter S Corporations face significant restrictions on such corporate relationships.
Summary. For most, the LLC provides a more flexible and easy to manage vehicle for their business entity. Plus, the traditional income tax drawback of an LLC is now reduced by the ability to be taxed as a Subchapter S Corporation. While some entrepreneurs and most medical professionals prefer to go straight to the Subchapter S form to leverage this advantage, there is much to recommend about the easier LLC form of entity. As always, careful consideration of your choices is advisable, with the participation of our firm and your other professionals.
Any accounting, business or tax advice contained in this Article is not intended as an in-depth analysis of specific issues, nor is it sufficient to avoid tax-related penalties. If requested, Lambert & Lambert PLC would be pleased to perform the requisite work on your matter. Such an engagement may be the subject of a separate letter that would define the scope and limits of the desired legal services.
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