If you’re an entrepreneur or small business owner pouring your heart and soul into building and growing your enterprise, the dream is that all of that hard work and investment will be rewarded with success. The nightmare is that you expose your personal finances to significant risk and tax liability that can bring that dream crashing down. One of the ways to minimize those risks and protect yourself is to pick and form the right business entity.
For small businesses, this choice often comes down to two potential corporate structures: a limited liability company (LLC) or an S-corporation (often called an “S-corp”).
As alluded to above, perhaps the most fundamental reason business owners form LLCs or S-corps is to protect their personal assets from business creditors or other liabilities arising out of the operation of the business. Both of these entity types can accomplish this crucial goal, giving owners much needed peace of mind.
However, that protection can be lost if the business owners conduct their affairs in such a way as to render the company a mere “alter ego” of its owners or if they engage in fraudulent conduct. Additionally, both entities provide the benefit of treating your business income as your personal income for tax purposes.
How LLCs and S-Corps are Different
While both LLCs and S-corps provide the benefit of protecting personal assets, there are several key distinctions between LLCs and S-corps. A few of those differences include:
- Both LLCs and S-corps are “pass-through” entities for tax purposes, which means business profits pass through the business entity and get taxed as the personal income of the owners. Here’s how it works:
- Single Owner LLCs. If you run a single-owner LLC, you are taxed like a sole proprietorship, which means you can simply attach a Schedule C form to your personal tax return.
- Multiple Owner LLCs. If your LLC has several owners, you can choose to be taxed as a corporation or a partnership.
- S-Corps. In an S-corp, the corporation’s income is reported on the shareholders’ personal income taxes, based on their percentage of shares owned, regardless if they received distributions of the corporation’s income.
- Allocation of Income. If you have others who will have an ownership share in the business, you will have to figure out how income will be allocated between you and your partners:
- S-corps don’t give you much of a choice, as income must be distributed evenly among all owners regardless of how much labor or money each owner has contributed to the enterprise.
- In an LLC, however, you can distribute income however you wish.
- Corporate Formalities. One of the appealing things about an LLC is that, as a general rule, fewer corporate formalities are required than in S-corps and certainly fewer than in regular corporations. But being too casual can lead to serious problems:
- As noted, failure to treat the LLC as a distinct entity by commingling funds, undercapitalizing the company, failing to hold meetings, etc. can result in the loss of that all-important personal liability protection.
- While Illinois LLCs are not required to have written operating agreements, I strongly recommend that a written operating agreement be drafted and signed by all members to clarify the parties’ rights and obligations and avoid future conflicts as to its provisions.
- Ownership Restrictions. An S-corp can have no more than 100 shareholders. By contrast, LLCs can have any number of owners and can even be owned by corporations and other LLCs.
There are numerous other nuances and distinctions regarding ownership, management, and operation of both LLCs and S-corps, and there are special types of LLCs called “Series LLCs” and “Low-profit LLCs” that may be best suited for your business. Additionally, there are other potential entities available, including general partnerships, limited partnerships, and specialized partnerships for the provision of professional services.
The Law Offices of Louis R. Fine
I understand that every business is different and that the goals and concerns of every business owner are unique. That’s why I work closely with my clients to evaluate their specific situation and determine which business structure will best set them up for success and growth. Please give me a call at 312-236-2433 or fill out my online form to arrange for your free initial consultation.