LLC or S Corporation?
Should I Set my New Small Business up as a Limited Liability Company or an S Corp?
It’s probably one of the most frequent questions we get at CorporateRecordsProgram.com: Should our Orange County business organize as a Limited Liability Company (LLC) or an “S” Corporation?
LLCs Are All the Rage in Orange County, California
Whether you ultimately decide to form an LLC or an S Corporation (Corp), there are strict legal, tax and management implications and details for both entities. And… it’s not a decision you should make on the fly.
Choosing the wrong entity can, in certain circumstances, expose you and other shareholders to all sorts of risks, liabilities, limitations and larger tax bills… sometimes ruinous ones. The biggest drawback continues to be the down and hard costs of maintaining the LLC in good standing with both the state of California (or any other state where you expect to establish your company’s headquarters) and the IRS.
LLCs appear to the uninitiated as the easy choice. On a first and cursory review, LLCs offer its members a passel of perceived perks over their S Corp brethren including:
- Flexible management structures
- Wider participatory opportunities (LLCs can include other corporations, individuals and foreigners as shareholders)
- Income distribution options
- Risk protection for individual members (similar to S Corps)
- Less paperwork
- And… fewer immediate tax costs
But (isn’t there always a truth or two or 20 that complicates the process?), there are more than a few limitations, complications and hard facts that contribute to an LLC’s legal, tax and financial exposure.
The Downside of LLCs
When it comes to it, LLCs are actually a good fit in only a few circumstances. Real estate ventures with more than one investor (and sometimes even with only one investor), for example, are a good fit for an LLC. An LLC is formed by filing “articles of organization” with the California Secretary of State before conducting business.
Generally speaking, LLCs are easier and faster to set-up with less management restrictions. However, as revenue and profit grow, taxes quickly balloon (with extreme junk fees on gross receipts in California), far outdistancing the tax liabilities of an S Corp.
Other LLC disadvantages include (but are not limited to):
- In California as well as many other states, the minimum $800 franchise tax is waived for corporations in their first year of business but not for LLCs.
- Licensed professionals are prohibited from doing business through LLCs.
- In California, tax rates for LLCs can approach up to three to four times (300%-400% higher) the tax rates that S Corps pay.
- Extending civil law protections to limited partners requires carefully crafted and vetted legal agreements.
- Licensed professionals (doctors, attorneys, accountants and others) cannot conduct business as an LLC. If participating members wish to form a corporate entity, they must use a corporation (or LLP for attorneys and accountants).
Doing Business as an “S” Corporation
At first glance it could appear that an LLC is a better organizational choice than an S Corp. However, an S Corp may provide greater civil protections for its members, fewer tax risks and no federal income tax.
Yes… S Corps limit shareholders, cannot accept corporate and other types of shareholders non US resident shareholders and are required to pay the minimum $800 California Franchise Tax regardless of its profits and losses. But an S Corp:
- Do not put its individual shareholders at risk for corporate losses, court ordered judgments and settlements, civil penalties or unpaid taxes, creditors can only look to the corporation for payment, even in bankruptcy
- California state taxes are limited to 1.5% of its net income (or $800, whichever is greater)
- Allocates income, losses, taxes and cash flow strictly to its individual shareholders on a pro rata basis.
S Corps typically have to maintain a strict management structure: shareholders nominate and elect directors who then appoint officers. And, although LLCs are much more adaptable, that flexibility comes at a price… as in increasingly complex operating agreements must be drafted as members, managers and other stakeholders change; much higher taxes as an organization prospers; and, again, professionals cannot operate through an LLC.
And, although the burden of holding an annual shareholder’s meeting and completing annual corporate minutes appears arduous, difficult and time consuming, the Corporate Records Management Program is designed to streamline this process at a reasonable cost.
The Big Difference
Despite the apparent and immediate advantages of an LLC, most of the clients we see here at the Corporate Records Program are really better suited to an S Corporate structure over the LLC. The “elephant in the room” is the 8.84% California tax rate on any taxable LLC income.
Do the math… unless your LLC plans to own real estate and generate very low gross revenue, the annual $800 tax liability of an S Corporation can be quickly dwarfed by the HUGE (almost 10%) tax the state levies on your LLC’s earnings. The scales quickly turn in favor of an S Corp over an LLC.
Although this page is not a substitute for professional legal, tax or financial advice and does not constitute an offer for such, we recommend you consult licensed legal (like the Corporate Records Program), tax and financial experts before choosing your organization’s ultimate corporate structure.
We’re confident that once you closely examine and compare the pros and cons in context with your organization’s plans, goals and member’s needs, you’ll see the S Corp is a better fit for most companies, especially in the long term.