Choice of Entity: Sub S v. C corp v. LLC: Questions to Consider

  1. Do you expect the company to provide extensive benefits (health insurance, etc.)? Do you need to carry large amounts of revenue (as opposed to investment money) from one year to the next, for example, for research and development? 

    If so, a "C" corporation should be considered. On the other hand, if a C Corporation has profits - though salaries and bonuses can often be set to minimize this - then there is double taxation: the "C" corporation pays taxes on its profits and the owners pay taxes on their salaries and any dividends. With Subchapter S corporations and LLC's, the profits and losses flow through to the owners in proportion to their percentages of ownership.

  2. If you are licensed under the California Business & Professions Code or under the Chiropractic Act or the Osteopathic Act, you cannot form an LLC to practice those licensed services. (Corp. Code Section 17375.) This group includes doctors, lawyers, accountants, licensed contractors, etc.

  3. Non-resident aliens may not be members of a Subchapter S corporation (although they may be beneficiaries of a small business trust that CAN be a member of a Subchapter S). For this purpose, the IRS definition is used: a non-resident alien is any non-citizen or legal permanent resident who has not resided in the U.S. for more than 182 days in any given year, as evidenced by the Substantial Presence Test (SPT). Persons who meet the SPT will be taxed primarily the same as legal permanent residents and citizens, which may include withholding of FICA from employment compensation. 

  4. Will the entity initially have any investors that are not individuals (in other words, corporations, LLC's, etc.)? Is the entity likely to have investors that are not individuals in the future? If so, how far in the future? (Subchapter S corporations can only have individuals as owners.)

  5. If you expect to have paper losses during the first year (or beyond), multiple your anticipated percentage of ownership in the company by the total of those paper losses. Does this amount exceed the value of items (cash, equipment, IP, etc.) that you personally will be contributing to the company? If so, by how much? (With a Subchapter S, you can only deduct losses up to the amount of your investment; with LLC's you can deduct all losses.)

  6. With a Subchapter S corporation, each owner has the same percentage of ownership, voting power, and profits and losses. With an LLC someone can have, for example, 25% of the ownership (meaning 25% of the proceeds if the LLC is sold), 10% of the voting power and 5% of the profits and losses. 

  7. Do you want to offer a stock option plan to employees? (You can offer profit-sharing plans instead, or give options for ownership in an LLC, although the latter is a bit awkward if more than a few people are involved. In any case, if you want to offer actual stock options, you need a corporation.)

  8. Does your tax advisor feel that, based on your personal tax situation, an Subchapter S corporation or an LLC would be better for you?

  9. Will the entity have large revenues compared with profits? (LLC's pay an extra tax based on revenues; Subchapter S corporation pay an extra tax based on profits.)

  10. Will you be receiving salary? (As a Subchapter S corporation shareholder, you pay the self-employment tax (equivalent to withholding for employees for Social Security and MediCare) on money you receive as compensation for services (you MUST take a reasonable amount as compensation), but not on profits that automatically pass through to you as a shareholder. 

    Each owner who is empowered to sign contracts on behalf of an LLC probably has to pay the self-employment tax on ALL money that they receive. (There are some other triggers as well.) By designating someone as the manager who is not a member (e.g., an affiliated corporation), all members may be able to avoid self-employment tax.) 

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Copyright 2004 Bruce E. Methven, All Rights Reserved.

The foregoing article constitutes general information only and should not be relied upon as legal advice.