Choosing a business structure that is best for your company is one of the toughest decisions that budding entrepreneurs have to make. Most small business owners choose between an LLC (limited liability company) and an S corporation. Forming a business entity is more complicated than most people think. A wise businessperson should hire an experienced corporate attorney to help him or her choose the best entity to form.
A Case of a Small Business Owner Deciding to be Either an LLC vs. an S corp
An owner of an E-cigarette business in California recently approached Andy Gale, a corporate lawyer from Business Attorney Orange County. This entrepreneur had a good business going. He owned a building where all his products were being manufactured, and he also had an operating business where all the cigarettes were being sold. The client approached Andy, because he wanted his company to prosper even more. He sought Andy’s legal advice on whether he should form a limited liability company vs. an S corporation in California.
Approaching a business lawyer is a wise move, because business entity formation is a very complicated process. Andy discussed with the client how a company forms an LLC vs. S Corp in California, and he said that the owner must first answer these 6 basic questions:
- How does the company make money?
- Who will be the owner of the business?
- Who is going to run the business?
- What are the company’s gross revenues?
- What are the projected net revenues?
- If there are more than 1 owners, how will the profits be split?
From these 6 questions alone, the client realized how complicated it is to choose a structure for his company. Answering these questions are merely part of the first step of the elaborately complex process of business entity formation. The owner was happy that he came to a competent corporate lawyer to help him choose between an LLC vs an S corp in California.
Choosing Between an LLC vs. an S Corporation Formation for your California Business? Here are 11 Variables to Consider
When company owners think that they can go through the process of business entity selection by themselves, they are not thinking clearly. They do not realize the complexity of the process, which is what the client from California came to understand as Andy explained what needs to be done. In order to properly select the appropriate structure for your business, you need to have a lawyer to guide you through the steps.
Besides answering the 6 basic questions, there are more steps to follow in business structure formation. Andy explained to the client that businesspeople still have to consider these 11 variables:
The purpose of your business largely determines whether it should be a limited liability company or an S corp. An LLC structure is ideal for those who want to build a holding company, which is a business that deals with real estate rentals and royalties. On the other hand, those who plan to put up an operating company should form an S corporation. Operating companies are businesses that provide services and/or sell products.
2. Find Out the Required Paperwork
Some people want to avoid preparing a lot of paperwork when forming an entity. For those who want less formalities, an LLC is the best structure to form. The government requires a huge number of documents from those who want to form an S corp.
If you are the type of business owner who wants to form an S corp, but avoid all the tediousness of preparing the formalities, it is highly recommended that you hire a corporate attorney. Competent business lawyers can prepare all the necessary documents for you.
Many trusted corporate attorneys strongly advice those who opt to form LLCs to file for the full alter ego limited liability protection. This is important because maintaining the formalities similar to those of an S corp are necessary to create a truly liability-resistant company. Even if you choose to form an LLC, you should hire a corporate lawyer to draft the necessary documents that will protect your company from liabilities.
3. Determine the Profile Company’s Owners
There are different prerequisites to being an owner of either a limited liability company vs. an S corporation. Owners of S corps need to be citizens of the United States, and should be currently residing in the country. Simple trusts can also be members, owners, or shareholders of an S corp. If you need help with building a trust, or finding the appropriate entity for your particular national residency, you can consult with Andy Gale at Business Attorney Orange County to set everything up properly.
4. Protection for Co-Owners
Some proprietors of businesses prefer an LLC structure because of the charging order protection for co-owners. A lot of them are not aware that they can get the same type of protection in an S corp, if they have a properly drafted buy/sell agreement between the shareholders.
5. Will There be Professionals Involved in the Business?
Many States allow professionals, such as lawyers, nurses, doctors, engineers, and accountants to form a professional LLC but not a regular LLC. PLLCs are specifically designed for licensed professionals.
In California, professionals are not allowed to form either PLLCs or LLCs, but they may form registered limited liability partnerships. If your business is in the State of California and you have professionals involved in the formation of your company, the only option you have is to form an S corp.
6. Determine How and Who Will Manage the Company
The management structure for an LLC is different from an S corp. If you plan to have an individual manage your enterprise, an S corp is the ideal entity to form. But if you want to have a company manage your business, an LLC should be formed.
What management system fits your business? If you choose a certain structure, what are the legal ramifications involved? These are questions that need to be answered, for you to choose the right entity. You can best answer these if you have a business lawyer to guide you.
7. Decide on How the Gains and Losses will be Allocated between Owners
Some entrepreneurs want to put in 1% of the money, but have different allocations of gains and losses. For example, a member wants to put in 10% of the money, but wants to take 90% of the losses. This kind of setup can be made in an LLC but not in an S corp. In an S corp structure, if a member is putting up 10% of the money, he or she is also going to get 10% of the losses or 10% of the gains.
In limited liability companies, money is taken through a draw. A draw is when an owner withdraws cash or assets from a business for personal use. These withdrawals are recorded with a debit to the owner’s drawing account and a credit to the cash account. In S corps, money is taken out through a salary, and then a dividend split.
How do you want to take money out of your business? This is something that will largely affect the ideal entity for your company. Consult a corporate lawyer on the implications if you choose either an LLC vs. an S corp structure.
9. Federal Tax
Federal tax for LLCs will vary depending on the entity that they used to be before their current structure. If the LLC used to be a sole proprietorship, a partnership, or an S corporation, no federal tax is required from the business. All taxes pass through to the individual returns. However, if the LLC used to be a C corporation, many tax issues are involved.
There are no federal tax requirements for S corporations. This is because all taxes pass through to each stockholder’s tax returns.
State tax varies from one State to another. In California, both LLCs and S corps need to pay the minimum franchise tax fee of $800. Besides that amount, LLCs have to pay a gross receipts fee, which depends on what the company’s gross receipts are. However, S corps only have to pay a net profit. An S corp’s net profit depends on the company’s gross revenues.
11. Personal Taxes
Personal tax in an LLC is different from that in an S corp in California. An owner of an LLC will pay income tax and self-employment tax on a draw, but the stockholders of an S corp will pay income tax and payroll tax on their salaries.
In an LLC, all distributions are subject to either self-employment tax or income tax, depending on how the owner is taking them. In S corps, however, distributions are subject to income tax only. This difference is one of the reasons why many small business owners who expect a lot of distributions prefer to form an S corp instead.
Choose the Right Business Entity by Hiring a California Corporate Lawyer to Help You Decide
Deciding whether to form an LLC vs. an S corporation in California? The process of choosing the appropriate business structure for your company can be very difficult. It is important that you choose the right entity for your enterprise, in order for you to avoid unnecessary problems in the future. The smartest way to do this is by hiring a top corporate attorney to help you decide.