If you’ve decided to create a startup business, one of the many decisions you face is the choice of what type of limited liability entity to form. In Wisconsin, the most typical choices are either the Limited Liability Company (“LLC”) or corporation. I frequently have people ask me whether I can help them set up an LLC for their business, and who often think, for whatever reason, that the LLC is their only option. My first response is always, “Is there a specific reason why you want to be an LLC?” and go on to explain that while there are some specific exceptions to this rule, a corporation is almost always the best type of limited liability entity for a startup small business compared to the LLC.
Why the Corporation is a Better Option
More Developed Law. In Wisconsin, the LLC has only been around since 1991, while the corporation has been around since 1848. Why is this relevant? There’s almost 160 years of law on corporations in Wisconsin, while there’s only 26 years of law on the LLC. This means there’s more settled law on issues with corporations and much more uncertainty within the law of LLCs. Where there are legal issues coming up in relation to your business, wouldn’t you rather have more certainty from years of developed corporate law than venture into the relatively undeveloped realm of LLC law?
Tax Considerations. Some argue that the LLC is preferable because it offers pass-through taxation to its members, meaning all income and loss the business has in a given year is spread according to the members’ equity stake in the business. You can easily elect for S-Corp status with the IRS to avoid the dreaded “double taxation” of C-Corporations and still get the same pass-through tax treatment given to LLCs. Corporations that elect S-Corporation treatment do have specific guidelines in regard to the number of owners, and the types of owners, but generally, those are irrelevant to most startups and small businesses. Since electing S-Corporation status allows for the same pass-through tax treatment for corporations, this puts the LLC and the Corporation on a level playing field.
Another huge tax benefit of the S-Corporation election is that, as an owner of the business, you only pay self-employment tax on the income that is attributable to the fair market value of your services provided to the business. If you are an LLC without a S-Corp election, you are taxed under Subchapter K of the Internal Revenue Code, and then must pay self-employment tax on all income allocated to you, no matter whether that income is attributable to your services as employee or not. For most small startup businesses, the owner also provides services as if she were an employee of the business, meaning that the employee/owner has to pay a self-employment tax on any income allocated to that individual in addition to income tax. In 2017, the self-employment tax is 15.3%.
In an LLC with no S-Corp election, no matter whether that allocated income is actually attributable to the services provided by the owner/employee, or whether that LLC level income is allocable to services provided by the employee owner and an employee non-owner, the owner pays all of the self-employment tax, AND income tax on top of that. For example, if an LLC had $100K of income that was allocated to the owner, the owner would pay the 15.3% self-employment tax as well as income tax on that amount, even if the owner only provided $50K worth of services as an employee of the LLC.
If the company had elected to be an S-Corporation, the employee/owner would only pay self-employment tax on the amount of income on the $50K attributable to her services as an employee/owner, and the remaining amount could be a tax-free “S-Corp” distribution that merely reduces the owner’s basis in corporation’s stock. This is a huge tax advantage, potentially saving thousands of dollars a year for S-Corp shareholders. Electing S-Corp is generally a good idea if your startup has employees or multiple owners, but you should always consult with a licensed CPA regarding whether this election would be beneficial to your particular business situation before doing so.
Investment Considerations. Finally, if you’re ever looking for equity investors like angel investors or venture capital groups, they generally prefer investing in corporations over LLCs. This is because, angels and VCs don’t want the extra income allocated to them for their share of profits from a pass-through tax structure at their higher tax rates, and prefer that their return on investment is paid through dividends (currently taxed at lower tax rates than ordinary income). When your business gets to the stage of looking for outside investment, depending on what your investors want, if you’ve elected S-Corp, you may want to revoke that S-Corp election to allow your investors to get the lower dividend rate, which is much easier than converting from an LLC to Corporation. Hopefully though, by that point in your business, you’re successful enough that the corporate level tax won’t be detrimental!
The Bottom Line
While there are situations where the LLC may be preferable for your particular business situation (which I’ll discuss in my next post), the corporate form is often still the better choice for most startups and small businesses . Choosing the type of entity now may seem like an insignificant decision now, but it may have a large impact on your business down the road. It’s best to consult with your legal professional to help you make the right choices when setting up a limited liability entity for your business. If you’re a startup that has already formed a limited liability entity or are thinking about starting a business and have questions about which type of entity to choose, email me at email@example.com or call me at 262-569-8300 to set up an appointment to discuss your options.