LLC vs S Corporation

Who cannot be an LLC:  Some businesses which must be licensed by the state of California are not allowed to be LLCs.  The Secretary of State has never issued a list of which businesses can and cannot form LLCs, but there have been some rulings on specific occupations.  If your occupation requires a state license, you should check with the Secretary of State or an experienced tax accountant before forming a California LLC.  A company which is organized as an LLC in spite of being ineligible loses many of its legal protections.  The Contractor State License Board can issue a contractor's license to an LLC.  However, the company is required to either carry $1 million of liability insurance or have $500,000 of liquid assets, so it is likely than only larger contractor companies will take advantage of the opportunity to operate as LLCs.

Who cannot be an S Corporation:  All shareholders of an S corporation must be either citizens or residents of the United States.  All of the shareholders must be individuals or estates, with a few exceptions.  All of the shareholders must have identical rights to distributions and liquidation proceeds. There are additional restrictions; check with your tax accountant.

Reasons in favor of an LLC

  1. The division of profits, losses, and deductions is more flexible with an LLC.  With an S corporation, profits & losses (after subtracting owners' salaries) must be divided in the same way that the stock is owned.  Example:  If 4 people each own 25% of the corporation, the profit or loss must be allocated 1/4 to each.  (But they may draw unequal salaries.)  In an LLC, the profits & losses can be divided however the owners agree.  Example:  4 partners each own 25% of the company, but 1 partner (who contributed all of the equipment) deducts all of the depreciation, and the remainder of the profit or loss is split 4 ways.
  2. An LLC with only one owner is a "disregarded entity" for tax purposes.  The LLC income and expenses are reported as part of the owner's tax return and no separate tax return is required. A husband and wife are counted as a single owner.
  3. With either an LLC or S corporation, if the company has a loss, it flows onto the owners' personal tax returns, where it is deductible if the owner has enough basis.  Basis can be thought of as the amount invested in the business.  LLC members may include their shares of company debt in their basis, and so may claim more losses.  Shareholders in S corporations cannot include their portion of company debt, except debt owed to that shareholder.  So, for example, being personally liable for the company's line of credit with a bank does not increase S corporation shareholders' basis, which may limit the amount of loss that is immediately tax-deductible.
Reasons in favor of an S corporation
  1. The owner may be able to reduce social security taxes by taking a reasonable salary and then taking the remainder of the profit as distributions.  This is only possible with an S corporation.  In an LLC, all profits allocated to a member who actively participates in the business are subject to self-employment tax. Over the years, there has always been talk of eliminating this tax benefit.  It could actually happen during the current budget crunch.
  2. On top of California's $800 annual minimum tax, LLCs with sales of over $250,000 pay an extra annual fee unless they have elected to be taxed as corporations.  The gross receipts fee ranges from $900 (for businesses with annual sales of $250,000 - $499,000) to $11,790 (for businesses with annual sales of $5 million or more.)  S corporations pay no gross receipts fee.
Other things to consider:

You can create an LLC, and then elect to be taxed as an S corporation.  Legally, you remain an LLC.  This is a private agreement between you and the IRS.  California goes along, too.

You may have noticed that I have not mentioned how quick and easy it is to form an LLC as a factor in favor of LLCs.  This is because I strongly believe that if a company has more than one owner, it is critical that you take the time to make a written agreement before the start of business.  It should address how profits & losses are to be shared, what happens if the company needs additional capital, what happens if an owner is disabled, dies, or decides to leave the company, and many other questions.

Whether you choose an LLC or an S corporation, your business should carry a large amount of insurance.

Other factors will also influence your choice of entity.  The purpose of the information presented here is to help you to be aware of the common concerns to be considered and to begin the conversation with your CPA tax accountant and attorney.

Bess Kane, CPA
August, 2020