Pass-through entities are a common entity choice for early-stage businesses (largely because it permits the losses of the business to ‘pass-through’ to the owners of the business for tax purposes.) If you choose to go this route, you now have another choice — the LLC or the S-Corp. How do you decide which is best?
A first-time entrepreneur often questions whether or not they should form an LLC or go the route of the S-Corporation. In a prior post, I wrote about general “Rules of Thumb” in picking a business entity. Several people asked for a bit more clarification on the differences between an LLC and the S-Corporation.
Both are pass-through entities (which will be treated similarly for tax purposes). Some of the reasoning for your choice will come down to your future plans for fundraising (are the planning to take VC money?) or the type of investors you plan to have early on (will you have investors who are all “natural persons” or could you need to have a corporate entity, foreign party or other entity as an investor?) or the flexibility you require in your entity structure (do you need to have a very unique/custom structure?)
Before you make any choices, it is always best to talk to your own attorney or accountant who can be sure you make the right choice for your own business and its specific circumstances.
If you’ve decided to take the plunge and operate your business as a pass-through entity, how do you choose between the LLC or the S-Corporation? Many high-tech entities find that if their business qualifies for the S-corporation election, it may be the better choice in the long run (given the ability to migrate to a C-Corporation with relative ease). However, in the event that your company will be unable to comply with the IRS’s S-corporation restrictions, you’ll find that LLC represents the next best choice.
To help understand the “downsides” of each of these choices (which hopefully will help you to identify the better or “right” choice for your business entity), the table below lays out some of the problems associated with each of these pass-through entities.
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S-Corp. and the LLC: The differences that matter
What else differentiates these two different types of entities? Downsides of an S-Corp · No more than 75 shareholders; · No foreign owners; · Only one class of stock; · Can easily fall out of compliance and lose tax benefits; and · Less flexible structure.
Downsides of an LLC · More complicated as its size increases; · More expensive state filing fees (typically); · May create tax issues if acquired by a third party; · Unable to issue ISO stock options (although other mechanisms do exist); · Unable to “write off” start up business losses; · Less “standard” which may increase compliance costs and attorney fees for preparation of operational documents; and · Does not have stock, which is sometimes more difficult/confusing for investors or employees.
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For another excellent resource, visit the Nolo website for an article on the differences.
This article is an excerpt from What Every Engineer Should Know About Starting a High-Tech Business Venture, available now.
