In the alphabet soup world of business structures, the trend lines are clear: The 900-pound gorillas known as “S Corporations” are under assault from the hard-charging “LLCs.” Understanding why this is happening is instructive to small business owners and prospective owners struggling with a decision on which structure to use.
Forbes contributor Steve Parrish recently gave his opinion on why S Corporations are declining. He said that S Corps are not dead, however they are increasingly at the mercy of government, creditors and benefit designers. His main point was that government taxes and our lawsuits make profitable businesses huge targets. The biggest advantage an LLC, or Limited Liability Company, has over an S Corporation is that its assets are much more difficult to legally access by litigants. Parrish explains that certain states have made creditor/debtor laws favor the debtors, and that LLCs do better under these laws:
“In many states, the creditor who successfully obtains a judgment against an LLC ends up with nothing more than a charging order. And more and more, these charging orders leave the creditor empty-handed because the debtor can delay or even eliminate collection.
What I’m finding is that businesses concerned about company liability issues are often being advised to form as an LLC, not as a regular corporation (otherwise known as C Corp). It’s suggested that this business form offers superior asset protection. In many cases, this also means owners gravitate towards “check the box” status as a partnership or sole proprietor for federal income tax purposes. This movement towards LLC legal status may portend a decrease in creation of regular corporations electing as an S Corp.”
Let’s take a step backwards for a minute. The S Corporation is far from dead. About 70 percent of all corporations filed as an S Corporation, according to IRS statistics. But if you are considering the LLC option for the first time, here’s what you need to know about that structure’s strengths and weaknesses.
The U.S. Small Business Administration capsulizes the differences between an S Corp and LLC:
“Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are ‘passed through’ the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.”
According to the SBA, there are three main advantages with an LLC:
- Limited liability. In essence, this means that members of the partnership are protected from personal liability for business decisions or actions of the LLC. This is not complete legal protection but could protect a business from nuisance litigation and families from liability.
- Recordkeeping. The LLC process is far less complex and cumbersome than forming an S Corporation. This is an attractive benefit in a world filled with growing paperwork requirements.
- Flexibility. An LLC can share its profits as it sees fit within the partnership. It is not as simple within an S Corporation.
The main disadvantage of an LLC is self-employment taxation. Again, the SBA explains:
“Members of an LLC are considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax.”
So, in essence, the cost of self-employment taxation weighed against legal liability and complexity is tipping the scales toward LLCs for many prospective business owners. Congress is always tinkering with tax structures so this trend is far from permanent. But for now, giving LLCs a close look might prove beneficial to your business’s long-term success.