The two most important considerations for most small businesses are 1) liability protection and 2) tax considerations. Textbooks sometimes cite other issues such as perpetuation of the entity, continuity, ability to raise capital, etc. However, in my experience, these are not important considerations for most small businesses.
- Liability Protection. With respect to liability protection, corporations (both C and S corporations) and LLC’s provide the same or similar limited liability protection. It is sometimes said that corporations may be more predictable because they have a longer history of legal case precedent to help decide issues of liability. Limited liability protection is also available in limited partnerships and limited liability partnerships but these forms are not frequently used for small businesses.
- Tax Considerations. With respect to taxes, the best advice is to project your net income for the next year or two and then ask your accountant or tax advisor to calculate which entity will provide you with the best tax savings. The information provides some basic considerations:
Special note: I often hear people say they have been told that an LLC is easier to operate than a corporation because there are no corporate formalities to observe. In my experience, this is simply not a major factor since both small business corporations and LLC’s are relatively easy to operate. I do not believe this should be a deciding factor in most cases.
If saving money on the FICA or the 15.3% self employment taxes is important to you, an S corporation may be the best entity of choice. The tax law requires that you pay reasonable compensation to the shareholders who work in the business. Many accountants define “reasonable” to mean approximately half of the net income of the business (this may vary depending on the nature of the business and what employees in similar businesses earn).
The proper FICA taxes must be withheld and paid on the compensation. The rest of the income which is distributed to the shareholders is not subject to the FICA taxes (it is, however, still subject to income taxes). Most accountants suggest that this same savings on FICA taxes is not currently available when using an LLC.
Special Note: Some tax advisors are recommending the use of an LLC which elects S corporation tax status. This is a fairly new approach that might provide the benefit of reduced FICA taxes coupled with the informal operating requirements of an LLC.
If you plan to leave most of the earnings in the business for purposes of expansion, then a C corporation might be most beneficial. This is because the first $50,000 of net income in a C corporation is generally taxed at a lower rate than the individual tax rates of S corporation shareholders or members of an LLC.
Thus, you can leave the first $50,000 of net income in the business and pay a lower tax rate. (You can leave net income in the business in both an S corporation and LLC but the shareholders and members will be required to pay income tax on the money at the end of the year, regardless of whether they actually received it or not, at their individual tax rates.)
If you plan on losing money or borrowing substantial money in the start-up phase, you should consider an LLC which may allow you to write off greater losses than you could if operating as an S corporation or C corporation. That’s because you get a little better tax basis when using an LLC.
There are some limitations on S corporation election. The rules require all shareholders to agree to S election and all shareholders must be citizens or permanent residents of the United States. S corporations are limited to 75 shareholders and to only one class of stock such as common voting stock. Other entities such as corporations or LLC’s cannot be S corporation shareholders with the exception of a few types of special trusts.
If you are planning on the business expanding rapidly and possibly going public, S corporations and LLC’s do not work as well. Even though you leave the net earnings in the business to expand it, you will have to pay income tax at your personal rate on the net earnings.
If there is a need to distribute income and allocate losses on a basis different than ownership ratios, then an LLC may work best. An LLC operating agreement can provide for a different allocation of profits and losses.(S corporations must allocate profits and losses strictly on the basis of the ratio of share ownership.)
For example, if some owners of the business need income but others need losses to write off against other income, an LLC allows the members to adjust these allocations based on their needs rather than strictly on ownership ratios.
Some experts believe that a business involved in the transfer and sale of real estate in and out of the entity might work best in an LLC. (This does not include real estate agents or mortgage loan brokers who earn a fee for their service but are not transferring title to real estate in and out of their entity.)
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