Answer #1: If now or soon contemplating employee stock options and/or bringing in outside investors, then corporation status is probably desirable.  And … you can later convert from S to C.

Answer #2: Otherwise, LLCs are more desirable.

Pass-Through Entities

Both S corps and LLCs are pass-through entities, meaning that income will not be taxable at the company level, but only taxable to the owners.  This distinguishes these 2 entity types from traditional “C” corporations, which must pay taxes both at the company level and later when distributed to the shareholders.

Tax Advantage – S Corps

S corps have one – potential – further tax advantage over LLCs, in the ability to effectively reduce an owner’s self-employment taxes by paying the owner a salary versus dividends.  So, for example, assuming two companies, one an S corp, the other an LLC, both earn $100,000 in income.  The S corp could pay the owner $50,000 in salary, and the $50,000 balance would be deemed dividend income to the owners or owners, and not subject to self-employment taxes.  The salary portion is subject to self-employment taxes, while the dividend portion is not.

Using the same figures for an LLC, the full $100,000 would be deemed income to the owner subject to self-employment tax.

In theory, that tax benefit of an S corp over an LLC could be significant, but with several important caveats: First, the IRS requires that a “salary” in fact be paid and that it be commercially reasonable, preventing low-balling the salary portion in order to manipulate tax savings.  And therefore, the income of the S corp would have to be fairly sizable before any tax savings become appreciable.

Second, the tax benefits of S corps will be offset – perhaps completely – by tax preparation and other costs.  An S corp, unlike many LLCs, must file corporate tax returns, and the salary brings accompanying quarterly and, possibly, monthly payroll tax filings.  These costs could be significant.

Third, because S corps are corporations, they must comply with state law corporate formalities in order to maintain their corporate liability protections, including holding meetings and keeping minutes.

Structural Flexibility – LLCs

The major structural advantage of LLCs is flexibility in ownership structure.  Multiple classes of ownership, multiple types of ownership, different rights for different owners within classes, and so forth.  So, for example, an S corp may not issue preferred shares, and may not issue convertible debt, and may not allocate profits and losses differently to different members of the same class of owners.  In fact, an S corp may not have different classes of owners at all, whereas all of these things are possible with an LLC.

Employee Stock Options

LLCs cannot – without much difficulty – issue incentive stock options to employees, unlike S corporations and C corporations.  And selling future shares in LLCs is also more cumbersome than with S corporations and C corporations.

Outside Investors – Venture Capital, Private Equity and UBTI

Many startups form as LLCs and later change to corporations when outside investors come in, and the process of re-formation or conversion is not difficult.  The problem for startups is that they don’t always have a great sense of how their future financial structure will evolve.  Unless outside investment is contemplated in the very immediate future, a good assumption is no assumption at all about what will happen.

Another somewhat obscure reason why venture capital and private equity funds may prefer a traditional corporate structure to LLCs is a preference against the pass-through benefits of LLCs, due to unrelated business taxable income (UBTI). As Bart Mallon explains in his excellent hedge fund blog, this antipathy, in turn, derives from the presence of tax-exempt investors in the investment funds, who must separately report – and be taxed on – “income derived by the hedge fund which does not relate to the [tax-exempt] activities of the tax-exempt investor.”  This problem doesn’t exist for the tax-exempt investor – through the investment fund – deriving income from investments in corporations, including dividends, interest, and capital gains, which income is deemed “passive”.  The IRS does not treat income from pass-through entities – including limited partnerships, LLCs and S corps – as passive, and therefore such income could constitute UBTI.  (See, for example, from Morgan Lewis, & Bockius’ “Deskbook Series”, Venture Capital and Private Equity Funds.  For this reason, private equity and venture capital funds with participation by pension funds, foundations, endowments and other tax-exempt – almost always require investments to be structured as non-pass-through traditional corporations.

Preference for LLCs

My preference is typically with LLCs, if only for the structural flexibility reasons, but also because of the general ease down the road of conversion or reformation if need be.  The reality is that outside investors, especially more established or sophisticated investors, will depend their own preferences in terms of corporate structure at the time of any such investment, and usually regardless of any previous planning that was done by the startup.

For further reading, I recommend these 2 excellent discussion threads among entrepreneurs and attorneys on this topic:

http://news.ycombinator.com/item?id=13752

http://answers.onstartups.com/questions/23890/approach-copyright-holders-to-licence-ip-for-my-game

One of the big attractions (to some) of LLCs is the almost complete LACK of legal requirements for annual corporate formalities.  I want to drill down a bit on this and examine how true this is, both in legal reality and in practical reality.

My guest today is Michael Steger, Principal of Law Offices of Michael D. Steger, PC, a firm with offices in New York City.  Mike’s practice focuses on litigation, intellectual property, entertainment, media, and corporate and other business matters.

Please click the link below for the podcast.

Draws versus Salaries

In an S-Corp, the shareholders are required to take salaries, not draws.  If an S corp shareholder takes out salary of $20,000, she will still pick up that $20,000 as W-2 income.  Taxes would have to be withheld, and shareholders would receive a W-2 at the end of the year.

In an LLC, members take “draws” rather than salaries, and taxes are not withheld on those draws.  A draw means an owner is just taking money out of the bank against the balance sheet account called partner draw (liability).  Instead, if an owner takes out $20,000 in an LLC, it doesn’t affect her ownership income, and she’ll receive a K-1 at the end of the year showing that $20,000 in income.

Unlike salaries in an S corp, LLC ownership draws do not reduce the company’s income.  A draw is not an expense, so although cash is decreased by the amount taken out as a draw, the payout of the draw does not constitute an expense that would lower net income of the company.  A salary is an expense account on the income statement that reduces your net income and your cash account.

Profits and Losses of the Company

In either case, shareholders or members will receive a K-1 from the company at the end of the year.  If the business has net income for the year (including deduction for salaries paid but excluding deduction for any draws) then that income will pass through to the owners on a K-1.

Therefore, while a company’s owners could reduce taxable income through salary payments in an S corp, they’re going to recognize the same total 1040 income through the combination of salaries and profit distributions via K-1.  Self-employment taxes (discussed below) will effectively cost them the same, and the only possible variable will be varying effects of marginal tax rates and capital gains treatment of profits versus salary.  (More on that last point under a separate posting coming soon.)

Self employment (SE) taxes

In an S-Corp, a shareholder is still (effectively) going to pay the full SE tax.  A shareholder cannot avoid SE taxes by taking salary rather than a draw, because while the company would indeed pay half of the SE tax, since the shareholder is essentially the company, the shareholder is effectively paying all of it.  And that would then be the same as if an LLC owner received all of here income on via owner draws.