Choice of Entity: Sub S v. C corp v. LLC: Questions to Consider
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.
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,
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.
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.)
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
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.
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.)
Does your tax advisor
feel that, based on your personal tax situation, an Subchapter S corporation
or an LLC would be better for you?
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.)
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.