If you are planning to form a business in New York, one of the most important initial decisions that you have to make is whether to structure it as a limited liability company (LLC) or an S (Subchapter)-Corporation. Although the LLC is typically the most preferred option, you should select the organization type that fits your particular business. While both entities provide limited liability and preferential tax treatment, there are some important distinctions you should take into account before making your election.
S-Corporation vs. LLC
What are the key differences between these two business structures? The simple answer is that an LLC is a business entity whereas an S-corporation is a tax classification for a corporation. An S-Corporation is an elective tax classification that offers liability safeguards and transfers income through to the owners. On the other hand, an LLC is a structured business entity that functions to protect its owners from legal actions. The main takeaway for aspiring business owners is that LLCs and S-Corporations require different management and shareholder approaches and entail unique reporting mandates. But what exactly does that mean? The following is a breakdown of each framework to assist you in choosing the best model for your new small business.
An S-Corporation is a standard company that elects to be treated as an S-Corporation when it comes to taxes. Per New York statute, new corporations are by default classified as a C-Corporation unless the entity files to be considered an S-Corporation by submitting an Election by a Small Business Corporation (Form 2553) to the IRS. Like normal LLCs, an S-Corporation represents a separate legal entity that may form contracts and perform business activities. New York state law requires that S-Corporations meet the following requirements:
- Issue stock
- Capping ownership at 100 individuals (not entities or partnerships)
- Limiting owner shares to U.S. citizens only
- Enact corporate bylaws
- Keep shareholder records
- Hold regular board meetings
- Record board meeting minutes
- No special share allocation with special benefits (e.g. A 20% shareholder may only receive 20% of benefits)
S-Corporations are “pass-through entities” which means that every shareholder claims all shares in both income and losses on their personal income tax returns, therefore no federal tax is owed by the entity. The profits of the business entity are essentially distributed to the owners, who then pay taxes on their share of earnings. As an additional bonus, by working for the S-Corporation and receiving a salary, an S-Corporation owner can aver stiff self-employment tax penalties that sole proprietorships typically have to deal with. Note, however, that New York City does not recognize S-Corporation status and thus entities receiving income from New York City-based sources will be subject to double taxation in the form of the city’s corporate tax.
S-Corporations are comparatively simple to set up compared to other formal business formats. Although some individuals choose to remain sole proprietors just to avoid dealing with formally incorporating their operation, the S-Corporation status provides enhanced credibility with potential customers, partners and suppliers. As noted before, just like C-Corporations and LLCs, S-Corporations also provide protection to the owners’ personal assets as the organization is considered a separate and distinct legal entity apart from the individual owners. Therefore, if the company becomes embroiled in litigation, the business assets may be at stake, but the personal financial assets of the owners would not be at risk.
S-Corporations do have some additional organizational restrictions that business owners need to be aware of. Only U.S. citizens or legal residents can form an S-Corporation and the number of shareholders is capped at 100. Also, S-Corporations have a mandatory equitable distribution/dividend to ownership ratio—meaning that if a shareholder owns 15% of the business, they can only receive 5% of income distributions. The shareholders are responsible for appointing a board of directors tasked with managing the day-to-day affairs of the business. The board must create bylaws, or rules by which the company abides. Shareholders that work for the entity are required to pay themselves a reasonable salary and withhold state and federal taxes, Social Security, FICA and unemployment taxes—all of which are exempt from the self-employment tax in addition to any dividends. Additionally, any shareholder salaries may be deducted from the corporation’s tax return as a business expense.
An S-Corporation elective tax classification may be a good fit for your company if you plan to scale in the future. Although it has more costs associated with formation and stringent guidelines to maintain S-Corporation status, the extra hassle could be worth it if your business has substantial income—generally entities earning over $90,000 annually should consider S-Corporations as a viable option. S-Corporations allow you to contribute money to retirement plans and optimally position your business for future expansion. What’s more, S-Corporations may be ideal for your business if you maintain a consistent level of growth. The 15.3% self-employment tax imposed on an LLC’s profit margin is a stiff tax liability when revenues are steadily trending higher. Essentially, if your LLC realizes a sizeable profit after paying owners a reasonable salary, you may save money in the long run in the form of taxes by transitioning to an S-Corporation. An LLC may also elect tax treatment as an S-Corporation.
Limited Liability Company (LLC)
An LLC is a legal classification that works as a protection for small business owners from personal liability in business matters. LLC owners are referred to as ‘members.’ LLCs may have a single owner or multiple owners. The default tax treatment is that for LLCs with only one member to be taxed as sole proprietorships, while LLCs with more than one member are taxed as partnerships. The benefits of an LLC are lower start-up and formation costs and added flexibility in terms of organization and profit distribution. Note that LLC owners can choose to have their LLC taxed as a C-Corporation or S-Corporation by filing the appropriate IRS form and meeting the requirements for their elected classification.
Forming an LLC may be the best move if you harbor concerns about potential personal liability, but seek to keep work associated with business upkeep and maintenance to a minimum. The legal requirements applicable to structuring and maintaining an LLC are minimal in comparison to S-Corporations. That also holds true for ownership and reporting guidelines. An LLC does not have a limit on the number of owners and can be formed by individuals of any nationality. As an added degree of flexibility, LLCs can be partially or entirely owned by partnerships, corporations, or noncitizens.
Get Started Today!
Starting a business is an exciting and monumental life event—but it can also be intimidating. Remember that you do not have to navigate the complex process by yourself. LOVE LAW FIRM has years of experience in all aspects of business formation across a wide variety of industries. Contact us today to learn more about how we can help you achieve your professional goals!
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Francine E. Love is the Founder & Managing Attorney at LOVE LAW FIRM, PLLC which dedicates its practice to serving entrepreneurs, start-ups and small businesses. The opinions expressed are those of the author. This article is for general information purposes and is not intended to be and should not be taken as legal advice.