In the course of my practice, when clients are starting a business or changing their current business structure, they ask which entity is better for their needs, an S-Corporation or an LLC. While both entities share similar qualities, they also have distinct differences. A client should review the pros and cons of each entity prior to deciding.
Pros and Cons of an LLC
The most attractive feature of an LLC is its operational ease. There are fewer initial registration requirements and no requirement to have formal meetings or maintain minutes.
LLC’s have fewer restrictions on sharing profits. Members may have contributed more money than others or worked more hours; the profit allocation may be altered to reflect this.
A negative aspect of an LLC is it has a limited life. A specific date is chosen when it terminates upon filing with the state. Additionally, when Member dies or goes bankrupt, the LLC will be dissolved.
The biggest drawback of an LLC is that the owner(s) of an LLC are considered to be self-employed and must pay the self-employment tax contributions towards social security and Medicare. The entire net income of an LLC is subject to this tax.
Pros and Cons of an S-Corporation
The most attractive feature of an S-Corporation is the tax savings. Only the wages of a shareholder are subject to employment tax. The remaining distribution is taxed at a lower rate, if at all. Compensation to shareholders must be reasonable or the IRS may reclassify. This is a red flag and you do not want this attention from the IRS.
An S-Corporation has independent life separate from its shareholders. If a shareholder dies or leaves, the S-Corporation can continue doing business.
The biggest drawback of an S-Corporation is that it has structural requirements such as director and shareholder meetings, minutes from those meetings, adoption, and updates to by-laws, stock transfers and records maintenance.
Typically with both entities, owners are not personally responsible for business debts and liabilities. Both entities have pass-through taxation (taxed at the individual level). Both are subject to state-mandated formalities and fees. I personally prefer the flexibility and lack of formal requirements of an LLC.