By: Starlin Colon
If you have been thinking about creating your own business, then you 
probably have read or heard that setting up a Limited Liability Company (LLC) is the best way to go about it. Although an LLC is generally a good option, forming an S-Corporation (S-Corp) could be a viable option as well, depending on the purpose of your future business. In this post, I will outline some of the benefits and drawbacks of forming an S-Corp as compared to the benefits and drawbacks of forming an LLC or other business entity type.
Formation
The first piece of information to look for when deciding to form a business entity is the initial procedures required to form the entity. For an S-Corp, the entrepreneur is required to file the articles of incorporation with the state. Each state sets out its own form for the articles, so they differ on what exactly is included in them. Generally, the articles include items such as the name of the S-Corp, names of the officers and directors, and the name of the individual incorporating the entity.
For an LLC, the entrepreneur must file the certificate of organization with the state. That certificate is similar to the articles of incorporation of an S-Corp as it identifies the company and the members, along with including optional information the member would like to include.
Liability
One of the main benefits of having either an LLC or an S-Corp is the fact that they both provide limited liability to the members or officers, respectively. Limited liability means that the personal assets of the individuals are generally protected in case the company is sued or goes bankrupt. The peace of mind of not having their personal assets at risk is extremely valuable to most entrepreneurs, and it most likely is to you as well.
Limited liability is not absolute, however, and could be lost in two main scenarios. First, an owner of a business may face personal liability through piercing the corporate veil. Courts may apply this remedy when the owner commingles the company’s assets with personal assets. This concept is true for both S-Corps and LLCs. Second, limited liability does not protect an individual from torts committed by that individual. This means that if you own either an S-Corp or an LLC, you will be personally liable for any torts you commit.
Taxation
There are several aspects of taxation that make S-Corps and LLCs very popular. First, both types of companies have pass-through taxation. Pass-through taxation means that the entity itself is not taxed. The profits or losses are passed to the owner and filed with the owner’s personal income tax return. This is a great advantage over other entity types since it prevents double taxation on the income where the company is taxed then the owners are taxed separately.
Self-Employment Tax. The self-employment tax is one big difference in taxation between the S-Corp and the LLC. This tax is the tax that owners of companies must pay for Social Security and Medicare. The current self-employment tax rate is 15.3%. This means that if you own an LLC, you will pay 15.3% of your income to the IRS in self-employment tax. In an S-Corp, the company would pay half (7.65%) and you would pay the other half. Although this may seem like the same amount, since you own the company, the advantage is that an S-Corp does not have to pay all of its profits to its employees in wages. The S-Corp is allowed to give distributions. Consider the following example:
You make a $200,000 profit. As a member of an LLC, 15.3% is paid as self-employment tax, which equals to $30,600. As an S-Corp, you could be paid a reasonable salary of $160,000, with the remaining $40,000 being given as a distribution not subject to self-employment tax. In this case, the company and you would each pay $12,240, for a total of $24,480. This is a tax savings of $6,120.
The self-employment tax benefit is probably the most common reason why a person would decide to form an S-Corp over an LLC.
Ownership
One drawback of forming an S-Corp over an LLC is that the IRS sets restrictions in the ownership and formation of an S-Corp. According to the IRS, an S-Corp:
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- must be domestic;
- cannot have more than one-hundred (100) shareholders;
- can only issue shares to individuals, not businesses;
- must have only one class of stock; and
- will have any subsidiaries added to the assets of the S-Corp.
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These restrictions are very different than LLCs and other business entities. LLCs can have members from anywhere in the world. There is no cap on the number of members, businesses can be members, and there are no restrictions on subsidiaries. If the IRS restrictions are not problematic for your business model, then it may be beneficial to form an S-Corp for the tax benefits.
Conclusion
If you are planning to start a company, think about the purpose of your company in order to better identify which entity would be the most beneficial to form. S-Corps and LLCs are very similar but have some big differences in the self-employment tax amount and the ownership restrictions. It is important to know the distinctions between types of entities in order to make an informed decision and prepare yourself for success.
*This post was checked for currency on February 9, 2019 and reproduced with permission by author Starlin Colon. Original post can be found here.
Starlin Colon, at the time of this post, is a third year law student from Penn State’s Dickinson Law. Originally from the Dominican Republic, he plans to take the bar exam in Pennsylvania. A Penn State grad, he is interested in business transactional law.
References & Photo Sources
http://uscode.house.gov/view.xhtml?req=(title:26%20section:1361%20edition:prelim)
https://www.corporatedirect.com/start-a-business/entity-types/s-corporation/
http://www.mainesbdc.org/llc-vs-scorp/
