I was recently asked to explain the difference between a Massachusetts Subchapter S corporation (S Corp) and a Limited Liability Company (LLC). As I was pondering the response, it occurred to me that this would make a great topic for a blog entry!
Both an S Corp and an LLC provide limited liability protection of personal assets against lawsuits and other liabilities of the business. Both also offer the benefit of the "pass-through" of profits and losses to the individual tax return of the shareholder/member, thereby eliminating the double taxation which occurs for standard business ("C") corporations. Other comparisons of the two highlight the differences.
1. Formalities of creation: Both are created by the filing of an organizational document with the Massachusetts secretary of state. The filing fee for a corporation is $275 (for up to 275,000 shares) and the filing fee for the LLC is $500. An S Corp also requires the additional step of filing a Subchapter S election with the IRS once the corporation is formed. Both must file an annual report each year with the Secretary of State. The annual report filing fee for a corporation is $125 per year and the filing fee for the LLC is $500 per year.
2. Formalities of Operation: An S Corp is governed by the corporations statute, which requires the creation of bylaws, the maintenance of formal minutes and other records, and the holding of annual meetings. The LLC has no such formal requirements, though the creation of an Operating Agreement is highly recommended.
3. Composition of Participants: An S Corp may have no more than 75 shareholders, all of whom must be U.S. citizens or have residency status. All shareholders must be individuals. Only one class of stock is permitted. The corporation is controlled by officers and a board of directors. In contrast, members of an LLC may be individuals or separate legal entities, U.S. citizens or not. There are no limits on the number of members permitted, and there may be different classes of members. An LLC may be run by the members or by managers who may not be members.
4. Allocation of Profits and Losses: With an S Corp, the allocation of profits and losses must be according to the ratio of each shareholder’s percentage of stock ownership, even if a different distribution scheme is preferred. With an LLC, profits and losses may be allocated to members in whatever manner the members wish regardless of their percentage of ownership. This, for example, would allow a member who contributes less capital but more "sweat equity" to receive a higher portion of profits despite a lower capital contribution.
5. Self-employment taxes: With an S Corp, income paid to shareholders as distributions is not subject to self-employment taxes; instead only the salary paid to an owner/employee is subject to self-employment tax. With an LLC, members are considered to be "self-employed" and, as such, must pay self-employment tax on all income received from the LLC. If the business operates in active trade, the members are active in running the business, and self-employment taxes on the members would be high, an S Corp may be preferred; the business can elect to pay a lower salary and more in distributions to minimize this tax. The downside of the S Corp in this context is that payroll taxes must be paid, and the paperwork associated therewith can be substantial.
So which is right for you? If your priorities are operational ease, flexibility with membership and allocations of profit and loss, and low maintenance, then an LLC might be your preferred entity. If you are looking to save on employment taxes and annual filing fees, and you don’t mind the structural limitations, then an S Corp may be right for you. In any situation, it is crucial to seek the advice of a competent attorney and accountant in order to make a fully informed choice.