The limited liability company (LLC) and S corporation (S-corp) are very similar organizational structures. Both offer the limited liability of a corporation with the pass-through taxation of a partnership. In California, both are subject to the minimum franchise tax, plus a tax on profits. Because they're so similar, it can be difficult for new entrepreneurs to decide which form to adopt for their business entities. But, despite those similarities on a general level, the differences between the two business forms are considerable. The peculiarities of California law sometimes mitigate and sometimes exacerbate these differences.
The corporate governance of an LLC is much less formal than an S-corp. Like any other corportion, an S-corp begins with the process of incorporation, which requires designated shareholders, directors, corporate officers, and a secretary. It must hold shareholders' meetings at least annually according to California law. There is no standard governance structure for an LLC, which is controlled according to the custom operating agreement designed by the members. The members of an LLC can act as mangers of the business, or hire separate management. In California, however, professional LLCs, that is those organized to provide particular professional services, are not permitted.
Another limitation of the S-corp relates to business losses that can be claimed as a tax deductions. The pass-through losses in an S-corp cannot exceed the owners' investment in the business. That makes a young and unproven S-corp a potentially poor tax haven in the early stages of development. An LLC has no such limitation and, in fact, is not even necessarily required to allocated losses among members in the same proportion as their relative ownership. That flexibility in allocating losses makes the LLC a popular choice for startups.
A major drawback to the LLC, however, is that any profits the business earns and that are distributed to the members is treated as self-employment income by the Internal Revenue Service (IRS). Members of a profitable LLC must file Schedule SE and pay self-employment tax on business profits they receive. The profits from an S-corp, in contrast, are taxed at the owner's individual rate. That, too, can be a drawback if significant profits push the owner into a higher tax bracket. In California as of August 2009, however, an S-corp is subject to a flat 1.5 percent tax on all profits, whereas an LLC is only taxed on income above $250,000 in a single year, a potentially significant savings that could offset federal self-employment taxes.
Another major difference between the LLC and the S-corp is the ability to issue dividends. An LLC cannot issue dividends, and therefore all income paid to members is self-employment income. Not only is income from an S-corp not subject to self-employment tax, but revenue transferred to the owner(s) as a dividend is taxed at a lower rate than regular income. The owner must accept a reasonable salary from the business, and pay income tax on it, but the rest of the business profits can come in the form of dividends taxed at a lower rate.
Finally, it is easier to convert an S-corp into a C-corp than it is to do the same with an LLC. That is important because, as a business grows, it will want to take advantage of the benefits of being a C-corp, such as having a larger number of shareholders. An S-corp has already been through the incorporation process, and changing between an S-corp and a C-corp is as simple as submitting a form to the IRS requesting one form of tax treatment or the other. Although an LLC can elect to be taxed as a C-corp, in order to be organized legally as an incorporation, an entire new entity must be created to acquired the LLC -- essentially a much more complicated and costly process considering a second California franchise tax and incorporation fees would become due.
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