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LLC vs S Corporation Business Structures For Buyers - What Are The Differences?

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Comments & Replies: 3     Views: 3191     Posted By: Due Diligence  



Topics: Buying A Business, Deal Structures, Legal Issues     Tags: buying a business, deal structures, legal issues


 
Contributor: Due Diligence, Valuations Advisor

With some frequency a potential buyer will ask if he should form a legal entity with which to operate the business once the purchase is finalized. The answer is generally yes when issues of liability and tax are considered. As liability is a question of law I will always suggest that an individual who wants to explore that subject confer with their attorney. However, I am always happy to talk to issues of tax.

There are positive and negative factors to operating in each form of business, but a few things in my mind are critical:

An LLC is essentially a partnership and a "flow through entity". The earnings of the entity are going to pass through to the members and be subject to both income tax and ( generally) self-employment tax. The self-employment tax is 15.3%, which represents both sides of the SSA and Medicare tax paid on wages in a salary man situation.

But wait there is more (love those statements in ads):

For all California source income the LLC will be charged a fee based upon income (sales) which ranges from a low of $900 to a high of $11,790 depending on the revenues of the business.

If you are planning to purchase real estate, have non resident aliens as investors, or plan uneven distribution of profits a case can be made for the LLC. Also professional service providers will often establish themselves in the LLC structure for reasons that need not be explored here.

The S corporation (also a Flow Through Entity) is more formal in it's structure and can have up to 100 shareholders, all of whom have to be US citizens or residents. Estates and certain trusts can be shareholders. It is critical that all distributions (but not wages) reflect the pro rata shareholder interests in the corporation.

However, if the shareholder operating the business is paid a "reasonable salary" the remainder of the profits are not subject to the self employment tax and a substantial tax saving can be achieved. The tax code does not define "reasonable salary" and the argument with IRS is always challenging. There are no additional fees paid to California in this type of entity, although they do assess a tax of 1.5% of net taxable income.

Do not put real estate into an S corporation.

The above is a simple analysis of the issues and should not be considered either exhaustive or formal. It is possible for an LLC to file income taxes as an S corporation but there are complex rules to this strategy.

The tax code is complicated and each individuals situation different. This requires that you consult with your own legal and tax advisors.


David makes good points about the differences in taxation between an LLC and S Corporation. When a client asks me the same question I always refer them to their tax advisor first, because the correct entity choice for one client may be different for another client depending on their personal tax situation.

From a legal perspective, both an S Corp and LLC can be excellent entities for business ownership, depending on your needs and how willing you are to do basic corporate maintenance. While an S Corporation isn't difficult to operate and maintain, if you don't take the simple steps needed to form and run it properly you'll lose the protections it can offer individual shareholders from losses and liabilities the corporation suffers. An LLC has fewer formalities, which means there's less to do to maintain those protections. The disadvantage to that is that many business owners form their LLC and then promptly forget to do any maintenance. While an LLC makes things easier, it doesn't eliminate the need for good corporate structure and record-keeping.

If you're planning on offering a stock grant or other equity-based incentive program, an S Corp is typically a better choice as its structure works well for granting and issuing additional ownership on an incremental basis.

Choosing your entity is best done with the help of both your tax advisor and attorney, who can walk you through your options and make recommendations based on your specific needs.


This is an excellent summary of the many factors to be considered in deciding what type of entity to use to purchase a business, which usually comes down to deciding between a "sub-S" corporation or a limited liability company ("LLC").

When I practiced law years ago in New Jersey, I told my clients that I was very competent and experienced in setting up their business entity and preparing their shareholder's agreement and other founding documents where appropriate, whether it was a sub-S or a LLC. But, despite all the written resources I could refer them to to determine which type of entity to use, their absolute best resource would be a professional business-oriented Certified Public Accountant -- and the buyer should "bite the bullet" and pay the cost for advice specifically tailored to their unique personal financial and tax situation. While the attorney should establish the entity, the CPA should determine which type of entity it should be.


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