S-Corps versus LLCs

The S-Corp is the most common form of business entity used in small business. Most entrepreneurs consult with their CPA about tax issues and an S-Corp is recommended. However, entrepreneurs can form a LLC and file IRS Form 2553 for a S-Election and their LLC will be taxed as an S Corporation. So why is an LLC better? Asset Protection. An ownership interest in an LLC has considerably greater creditor-protection than shares in an S corporation, which can be easily seized by a stockholder’s personal creditors.  A member’s interest in an LLC is creditor protected in the same way a partner’s interest in a limited partnership is protected.  A member’s personal creditor is limited only to a charging order against the LLC interest.  This gives the creditor only the right to receive distributed profits due the debtor partners. As you will read under Income Distributions, LLCs have the ability to distribute the income as the members agree. This is one reason it is incredibly important to have a robust Operating Agreement in place before a creditor sues your LLC.

Corporate Formalities:

S Corporations were based off of the C Corporation, therefore,  the S Corporation involves structure, formalities and compliance obligations. These obligations can be too burdensome for the solo entrepreneur, in other words, a “payroll of one.” If you incorporate as an S Corporation, you need to set up a board of directors, file annual reports and other business filings, hold shareholder’s meetings, keep records of your meeting minutes, and generally operate at a higher level of regulatory compliance than your business might need or want to deal with. With the LLC, this isn’t the case. LLCs just use an informal operating agreement. Why does this matter? Most small business owners start up a S Corp and then fail to comply with the corporate formalities. If they get sued the corporate veil can be pierced and their personal assets can be at risk. To help our clients deal with this issue we off the Corporate Shield™ Service.

The Takeaway: If you want less red tape and formality, the LLC can provide greater simplicity.

Income Distributions

In an LLC, income and loss can be allocated disproportionately among the owners. By contrast, in the S Corp, income and loss are assigned to each shareholder strictly based on their pro-rata shares of ownership. This is an important distinction to understand. For example, let’s say two friends, Stefan & Brandon, open a law firm, each owning 50%. As the year progresses, Stefan needs to focus his time elsewhere, while Brandon does all the work. Their business becomes more profitable than they ever imagined, and they want to divide up the profits. Because Brandon has put in the bulk of the work, the two decide he should keep 75% of the profits, and Stefan should get 25%.

With an LLC, this type of agreement is fine. The two owners simply agree to the arrangement and they will be taxed accordingly to their “operating agreement.” But this type of flexible arrangement won’t work with an S Corporation. Because Stefan and Brandon are each 50% owners, each will be allocated 50% of the corporation’s income, at least when it comes to computing income tax.

The Takeaway: If you need flexibility when it comes to splitting up profits among owners, the LLC is the preferred structure.

Tax Elections

S Corporations can be taxed as a S Corporation.

LLCs can be taxed in the following ways: C-Corp, S-Corp, Sole Proprietor, Disregarded Entity, or Partnership.

The Takeaway: If you need flexibility when it comes to tax elections, the LLC is the preferred structure.

S-Corp to LLC Conversions

Arkansas Law provides an organization other than a limited liability company may convert to a limited liability company if the provisions of the Arkansas Small Business Entity Tax Pass Through Act are complied with. Many people will tell you that converting your S-Corp to an LLC is a taxable transaction. It can be a taxable transaction, however, it can also fall under § 368(a)(1)(F) of the Internal Revenue Code. The business will be taxed the same, but it will have less corporate formalities and greater asset protection.