Establishing a business as a sole proprietorship provides no legal protection to you and is not advised. Starting out, new small business owners typically opt for setting up the business as an LLC or an S-Corp. Between the two, S-Corp. seems to be more popular. For a comparison between the two, see below:
LLCs and S corps have much in common:
- Limited liability protection. With both, owners are typically not personally responsible for business debts and liabilities.
- Separate entities. Both are separate legal entities created by a state filing.
- Pass-through taxation. Both are typically pass-through tax entities, and while S corps must file a business tax return, LLCs only file business tax returns if the LLC has more than one owner. With pass-through taxation, no income taxes are paid at the business level. Business profit or loss is passed-through to owners’ personal tax returns. Any necessary tax is reported and paid at the individual level.
- Ongoing state requirements. Both are subject to state-mandated formalities, such as filing annual reports and paying the necessary fees.
Differences in ownership and formalities
Ownership. The IRS restricts S corporation ownership, but not that of limited liability companies. IRS restrictions include the following:
- LLCs can have an unlimited number of members; S corps can have no more than 100 shareholders (owners).
- Non-U.S. citizens/residents can be members of LLCs; S corps may not have non-U.S. citizens/residents as shareholders.
- S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships or many trusts. This is not the case for LLCs.
- LLCs are allowed to have subsidiaries without restriction.
Ongoing formalities. S corporations face more extensive internal formalities. LLCs are recommended, but not required, to follow internal formalities.
- Required formalities for S corporations include: Adopting bylaws, issuing stock, holding initial and annual director and shareholder meetings, and keeping meeting minutes with corporate records.
- Recommended formalities for LLCs include: Adopting an operating agreement, issuing membership shares, holding and documenting annual member meetings (and manager meetings, if the LLC is manager-managed), and documenting all major company decisions.
Differences in management
- Owners of an LLC can choose to have members (owners) or managers manage the LLC. When members manage an LLC, the LLC is much like a partnership. If run by managers, the LLC more closely resembles a corporation; members will not be involved in the daily business decisions.
- S corps have directors and officers. The board of directors oversees corporate affairs and handles major decisions but not daily operations. Instead, directors elect officers who manage daily business affairs.
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