Question

Bob, who is a close friend, has decided to start his own consulting firm. He has received conflicting information regarding the best business structure to reduce his tax liability. He will be the only employee; however, he is willing to consider creating an S-Corporation. Compare and contrast the benefits of Corporations, LLCs and S-Corps and make a recommendation regarding which would be the most advantageous for Bob. Defend your position. Please provide me some additional information that is not already answered.

Answer 1

The advantages of a C-Corp include:

1. C-Corps are a more favorable setup for employee compensation. If the company plans to create incentives (i.e. stock options) to attract and keep employees normally prefer C-Corps.
2. C-Corps allow the owners to take advantage of certain provisions in the tax code with respect to exclusion of a certain amount of capital gains and the deduction of certain losses.
3. Non-US citizens and/or non-residents are permitted to be shareholders/founders of a C-Corp.
4. Ownership is unrestricted therefore C-Corps are often the best choice for large companies that are or plan to be publicly traded.

The disadvantage of a C-Corp is double taxation. The first taxation takes effect at the corporate level, on the corporation’s net income. The second taxation takes effect at the shareholder’s level, when or if the profits are distributed to business owners as dividends.

The advantages of an LLC include:

1. Flexible management structure. There is no requirement for a formal management structure.
2. There are no ownership restrictions and members of an LLC can be non-US citizens or non-resident aliens.
3. Flexible tax regime. An LLC can choose to be taxed as a sole proprietor, partnership, S corporation, or C corporation. By using default tax classification, profits are taxed personally at the member level, not at the LLC level.
4. LLCs can be set up with just one natural person (depending on the state) and thus partially separates the liability of a company from that member.
5. LLCs can offer membership interests in the LLC to employees.

The disadvantages of an LLC include:

1. Investors may be wary of the LLC structure and prefer the traditional corporate structure of a C-Corp or S-Corp. This can make raising capital difficult for LLCs.
2. Some states levy a franchise tax on LLCs, which is basically a fee to pay for the privilege of the LLC status.
3. Renewal fees may be higher than a C-Corp or S-Corp.
4. LLCs are not considered corporations for the purpose of the civil procedure. Instead, they are treated as partnerships by a court. This affects diversity jurisdiction.
5. The equity compensation process for employees is not straightforward and standard incentive stock options employed by C-Corps are not typically available.

The advantages of an S-Corporation are:

1. They only pay one level of taxation, which is at the shareholder level.
2. An S-Corp does not have to be chosen at the time of incorporation.
3. In addition, a start-up company can choose an S-Corp if the founders wish to benefit of a flow through tax treatment. They can elect to be a S-Corp before the financing stage and revoke S-Corp status at the time of financing

The disadvantages of a S-Corporation are:

1. Limited ownership to 100 shareholders, who cannot be non-resident aliens, nor can they be owned by other corporations.
2. Cannot have multiple classes of stock.
3. Are not allowed to conduct certain types of businesses.
4. Less flexible than C-Corps for employee fringe benefits.
5. Must report employee taxable compensation.

After reviewing the advantages and disadvantages of all three entities, I would explain to Bob it would be most advantageous for him to form an LLC, while eventually being taxed as an S-Corp. To begin, his personal assets would be protected from creditors of the business. Basically stated, limited liability means Bob cannot be responsible for more than his investment in the company. It is normally only a single page form to set up a single member LLC. Additionally, it is fairly inexpensive, and there is not as much “red tape” when creating an LLC. If the time comes that Bob’s business begins earning more revenue, he can choose to become taxed as an S-Corp. By being taxed as an S-Corp, Bob will save money when it comes to paying taxes. Bob would get the legal benefits of running his business as an LLC while saving money by being taxed as an S-Corp.