The entity structure known as a Limited Liability Company (LLC) offers a lot of flexibility for small businesses. There are four options for an LLC, 1) to be treated as a partnership, 2) as an S-Corporation, 3) as a Corporation or 4) as a single member LLC. While all offer limited liability protection for the owners, they differ greatly in their structure. In this blog post we will only focus on the LLC as a partnership and an S-Corporation.

An LLC S-Corporation is best for owner operators who do not plan on seeking funding from an external investor. In an S-Corporation the allocation of profits or losses are pro-rata based on ownership percentages. This is true for distributions, known as dividends, too. For example, if Shareholder X needed a $5,000 distribution to help pay for his income taxes associated with the profits allocated to him via the S-Corporation then Shareholder Y (assuming 50/50 ownership split) would also receive the $5,000 distribution whether or not you wanted to distribute money to Shareholder Y.

The LLC S-Corporation is attractive to many new business owners because of how FICA taxes are treated for owner wages. Note: owner wages in an S-Corporation must be reasonable (see your tax adviser for more information). In an S-Corporation one-half of the FICA taxes on wages are paid by the company and the other half is paid by the employee (which is the owner). In an LLC partnership the Guaranteed Payment is not subject to any tax withholdings and instead ALL earnings from the LLC are reported and paid on the individual income tax return as self-employment earnings. Truly, the overall tax savings with an S-Corporation is minimal, depending on the profits of the entities, and should not be the sole item the entity choice is based upon.

With an LLC treated as a partnership the profit or loss allocations as well as distributions need not follow ownership percentages; however, they must have economic substance. Therefore, an LLC partnership is a great tool for businesses that will required outside funding from an investor.

Before deciding which option (S-Corp or partnership) is best for your business consider these items:

1. Who is the source of funding? You, a bank or external investor?

2. How do you want profits or losses allocated? In proportion to ownership or another formula?

3. Will one or more owners receive regular distributions?

4. What are the future plans for this business? Do you plan on selling in 5 or 10 year? Maybe you plan on converting the LLC to a Corporation to prepare for a public offering? Which structure will result in the least amount of cost to do so?

5. Ease and maintenance of entity structure. S-Corporations require a Board of Directors and annual meetings must be held and the minutes must be filed with the state. Also, there are limits on the number of and types of entities that can be shareholders.

Choosing the right entity structure for your business is important for many reasons. Be sure to ask your CPA or attorney to support the reasons they are recommending one option over the other.