S-Corps and LLCs are similar but have important differences concerning liability, tax, membership, ownership by other entities, ownership of subsidiaries, transferability of ownership, distribution of units or stocks, corporate formality, management, and allocation of profits and losses.
Liability: An S-Corp and an LLC each enjoy limited liability.
Tax: Like an LLC, an S -Corp uses pass-through taxation, meaning an owner claims a share of company profits on their individual tax return. This ensures profits aren't double-taxed (once under the corporation and again under the owner). The LLC, however, may choose not to be taxed as a pass-through. S-Corps may have preferable self-employment taxes compared to the LLC because the owner can be treated as an employee and paid a reasonable salary.
Internal Ownership: The IRS treats S-Corps and LLCs differently concerning ownership by the members of an LLC versus the shareholders of an S-Corp. The IRS rules restrict S -Corp ownership, but not that of LLCs. LLCs may have unlimited members; the S-Corp is limited to no more than 100 shareholders. Non-U.S. citizens/residents can be members of LLCs; an S-Corp may not have non-U.S. citizens/residents as shareholders.
Ownership by Another Entity: LLCs may be owned by a corporation, LLCs, partnerships, and trusts. Because an S -Corp must be owned by individuals, trusts, or estates, its stock cannot be held by another S -Corp, a C corporation, an LLC, or a partnership. Purchasing shares of another S -Corp voids that company's election of S-Corp treatment.
Ownership of Subsidiaries: There are no restrictions on ownership of subsidiaries by an LLC. The S-Corp may establish a subsidiary as an LLC, a C-Corporation, or qualified subchapter S subsidiary, known as a QSub.
Transferability of Ownership: Assuming the S-Corp follows the IRS ownership restrictions, its stock is freely transferable. Absent approval from other members or as provided otherwise in its operating agreement, An LLC membership interest (ownership) is not freely transferrable.
Distribution of Units or Stocks: LLCs may (but not are required to) issue units; an S-Corp issues stock. LLC’s may distribute units with different financial rights; an S-Corp may not provide some stockholders a preference to distributions over other shareholders.
Corporate Formalities: In general, an S-Corp is subject to more extensive formalities, which include adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings, and keeping meeting minutes in corporate records. The LLC formalities are not as extensive, but should include adopting an operating agreement, issuing membership shares, and holding and documenting annual member meetings (and manager meetings if the LLC is manager-managed). The owners should practice good housekeeping by documenting all meetings and company decisions.
Management: As opposed to an S-Corp, the LLC enjoys flexible management. Owners of an LLC may have members (owners), or managers manage the LLC. When members manage an LLC, the LLC is similar to a partnership (or a sole proprietorship if there is only one member). If run by managers, the LLC resembles a corporation, because members are not involved in the daily business decisions. On the other hand, S-Corps have directors and officers. The board of directors oversees corporate affairs and handles major decisions but not daily operations. Rather, directors elect officers who manage daily business affairs. Shareholders do not manage the business and affairs.
Allocation of Profits & Losses: Shareholders of an S-Corp receive profits and losses based on their percentage of ownership. An LLC allocates profits and losses as provided in the operating agreement (e.g., member with a 30% ownership interest could be entitled to 70% of the profits and losses).
In essence, an LLC and an S-Corp are generally alike regarding limited liability and pass-through tax. There are major differences concerning membership, ownership by other entities, ownership of subsidiaries, transferability of ownership, distribution of units or stocks, corporate formality, management, and allocation of profits and losses.
Call one of our Transactional Attorneys at Goosmann Law Firm today to tailor a corporate entity that suits your business!