Whether you are still in the process of formulating your business brainchild or have been successfully growing your NYC-based business for years, you should consider what type of legal business entity best serves the short- and long-term financial needs and goals of that business. Two of the most common entity types for both up-and-coming and long-established businesses in NYC are LLCs and S-Corporations (or “S-Corps” as they are commonly called).
Make no mistake, you are free to operate your business – whether solo or with others – without going through the steps to formally create an LLC or S-Corp, which in many cases would cause state, local, and federal authorities to view you as a sole proprietorship (if operating alone as a business owner) or general partnership (if you co-own the business). But doing so may not result in the most favorable tax treatment, and, even worse, may lead to unlimited personal liability, meaning not only would your business be at risk of going bankrupt over a careless mistake, but you yourself might be at risk as well.
Both LLCs and S-Corps offer the benefit of “limited liability” meaning that, in most (but not all) cases, only the business itself would face liability from third parties for matters like breach of contract, malpractice, or personal injury lawsuits. The business owners would not be personally liable outside of what assets were invested in the business. Before you form either an LLC or S-corp, there are key differences you will want to understand with regard to formalities, operating arrangements, taxation and other issues.
The Benefits of an LLC
As stated above, a key benefit of an LLC is the limited liability for obligations that the owners of the LLC enjoy (which is, of course, apparent in the unabbreviated term “Limited Liability Company”), unlike sole proprietors and general partners who face unlimited personal liability for company obligations, even if another partner’s actions caused the liability.
In addition, members (meaning owners) of an LLC can enjoy a more favorable tax treatment than they otherwise would, which can include the passing-through of business profits (meaning they will not be taxed at the corporate level) if they so choose. Members also have the flexibility to choose among a variety of tax treatments, including S-Corp taxation, C-Corp taxation (which does result in taxation at the corporate level), or taxation as a partnership or sole proprietorship. LLCs which only have one member are not required to file a formal partnership tax return (Form 1065), although those with more than one member must do so.
LLCs in New York also enjoy more flexibility than S-Corps in how they apportion profits and losses and distributions. LLC members are free to agree via an operating agreement to uneven distribution of profits and losses (e.g. a member can receive more or less profits – or incur losses – than is proportionate to his or her ownership stake in the LLC). Similarly, LLC members are free to agree to make distributions as they see fit.
This flexibility extends to the ability of LLCs to have as many members as they would like, which can include foreign investors, and they may create different classes of members who have different rights and obligations with regard to the LLC. Finally, an LLC can easily convert to a corporation should its members decide to do so.
The Cons of an LLC
Unlike S-Corp owners, members of an LLC must pay all applicable self-employment taxes on distributions, meaning Social Security and Medicare taxes will apply. Additionally, if the LLC is doing business in NYC, the NYC Unincorporated Business Tax could apply to distributions as well. While business losses can be factored into the members’ individual taxation situations, use of such losses may be limited depending upon the member’s level of participation in the LLC.
In New York, LLC members may not be put on the payroll of the company, meaning the members will be dependent upon distributions. New York also requires LLCs to go complete specific business formalities to operate, including filing annual reports and paying fees to the state. Finally, LLCs may be required to have a limited life span; for example, Technical Termination rules may apply when there is a “sale or exchange” of 50% or more of the total interest in “capital and profits” within a 12-month period.
The Benefits of an S-Corp
Again, as with an LLC, a primary upside to forming an S-Corp over a sole proprietorship or general partnership is the limited liability its owners will enjoy, a benefit that cannot be overstated. Note, however, that this protection will only be meaningful if the owners have not pledged assets to the S-Corp or personally guaranteed the corporation’s debt.
The profits of S-Corps are not taxed at the corporate level by either the federal government or New York State, and instead pass-through to the owners who will claim them on their individual tax returns (note that LLCs may opt for this tax treatment as well). That said, NYC may locally levy corporate taxes on S-Corp profits. Additionally, losses from the S-Corp may be claimed without limit by all shareholders (S-Corp owners are referred to as “shareholders” rather than “members”). And, unlike with LLCs, the distributions of S-Corp profits will not be subject to Medicare and Social Security taxes.
Shareholders of S-Corps can also be added to the company payroll, and must be paid a reasonable compensation. In another key difference from LLCs, S-Corps have an indefinite life span and may continue even if shareholders sell their stakes to new shareholders.
The Cons of an S-Corp
For all the benefits of S-Corps, their owners have less flexibility and favorable treatment than LLC members in a few key areas. S-Corps in New York may not have more than 100 shareholders, and those shareholders may only be U.S. individual citizens, trusts, or estates, meaning partnerships, corporations, or non-resident alien cannot be S-Corp shareholders (also note that not all states allow for the formation of S-Corps).
Unlike LLCs, S-Corps cannot distribute profits and losses disproportionately to their shareholders’ ownership stakes, meaning a 25% owner can only receive 25% of profits (or losses) without flexibility. It should be noted that, with regard to losses, a shareholder’s basis in the corporation does not include any of the corporation’s debt, even if the shareholder personally guaranteed it, which limits the amounts of losses that be passed through to a shareholder.
Similarly, S-Corps may have only class of stock, meaning shareholders will have the same rights and obligations as one another. Not only that, while shareholders can be employees of the company, shareholder-employees with more than 2% ownership interest are not entitled to many tax-favored fringe benefits available to employees or regular corporations.
Finally, because an S-Corp is indeed a corporation, there are corporate formalities that will apply to the S-Corp. This can include filing corporate paperwork with the state, having formal procedures in place for board meetings and meeting minutes, and creating additional corporate bylaws.
Speak to a Business Formation Attorney For Guidance on Your Particular Business
Every business is different, and while the above is meant to provide broad outlines of the differences in regulations and treatments for LLCs and S-Corps in New York, a corporate formation attorney can provide particularized guidance to your situation. Contact a corporate formation attorney at The Fried Firm to determine the best course of action for your business.