The Pros & Cons of an LLC Vs. an S Corp in Virginia

by Joe Stone
Forming either an LLC or S corp can be beneficial for you business.

Forming either an LLC or S corp can be beneficial for you business.

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Starting your own business requires making a number of important decisions, one of which is deciding what type of legal structure you want to form. Many business owners typically choose between a limited liability company and S corporation, both of which protect your personal assets from your business debts. Virginia law governs the formation of both of these legal structures.

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Forming a Virginia LLC

The Virginia Limited Liability Company Act governs the formation of a Virginia LLC. A document called the articles of organization must be filed with the Virginia State Corporation Commission along with the appropriate fee. A template form of the articles is available for downloading on the commission's website, which also provides an online filing option. After the commission accepts the articles and the required filing fee, the LLC comes into existence. Owners of an LLC are referred to as "members."

Forming a Virginia S Corp

Forming a Virginia S corp is a two-step process. Similar to an LLC, a document must be filed with the State Corporation Commission, which is called the articles of incorporation. The commission also provides a template form for the articles and offers an online filing option. After the commission accepts the articles along with the filing fee, the corporation comes into existence. Owners are referred to as “shareholders.” However, when a corporation first files its articles, it is a "C" corp, not an "S" corp. To become an S corp, the corporation must file Form 2553, called a “Subchapter S Election,” with the IRS. By making a Subchapter S election, the S corp avoids the “double taxation” problem involving a traditional C corporation's profits. A C corporation is taxed as a separate entity and must report profits and losses on a corporate tax return. The shareholders must then report dividends as income on their personal tax returns. With an S corp, the corporation itself does not pay any income taxes; instead, the individual shareholders must include their shares of the corporation’s profits on their personal tax returns, paying tax at their individual tax rates.

Ownership Restrictions

An S corp and LLC differ significantly regarding ownership restrictions, which is due to IRS regulations. To qualify as an S corp, the IRS requires that an S corp have no more than 100 shareholders and only one class of stock. The IRS also prohibits an S corp from having shareholders who are legal entities, such as partnerships and other corporations, and also excludes non-resident aliens as shareholders. By comparison, the IRS regulations do not place any such restrictions on the members of an LLC, which can be unlimited in number and include all types of legal entities. Virginia law permits both S corp shareholders and LLC members to restrict ownership by making a written agreement that limits the conditions under which an ownership interest can be transferred.

Management and Organization

The requirements for management and organization of an S corp and LLC are governed by Virginia law, which may provide the greatest contrast between these legal entities. After incorporating, Virginia law requires an S corp to conduct an organizational meeting at which bylaws must be adopted, a board of directors elected, and the appointment of as at least a president and secretary, as well as any other officers deemed necessary. The S corp must hold an annual meeting of shareholders and keep a permanent record of minutes of all meetings. No similar requirements exist for an LLC, although Virginia law permits LLC members to create an operating agreement that will govern the LLC's activities and each member's rights and responsibilities. The members can also choose to have each member involved in managing the LLC or limit management to one or more members. One person can form and solely operate both an S corporation an LLC.

Distributions

An S corp has strict rules regarding distributions to its shareholders. Both Virginia law and IRS regulations require that all distributions be made to each shareholder on an equal basis. For example, if one shareholder is paid a dividend rate of $100 per share and another shareholder paid at $150 per share, the S corp can lose its tax status and will be taxed as a traditional C corporation. By contrast, an LLC's members can choose how to allocate distributions among the members. The only requirement is that the members make an agreement specifying the allocation before distributions are made.

Subchapter S Election for an LLC

The tax options for an LLC are the most varied for any legal entity because the IRS disregards an LLC's entity status for tax purposes. An LLC with more the one member has the option of being taxed as a partnership or corporation. If the LLC has only one member it can also choose to be taxed as a sole proprietorship; however, this latter form of taxation involves a significant liability for self-employment tax. To reduce this liability, a single-member LLC can opt for corporation tax treatment and then make a Subchapter S election. As an S corp for tax purposes, the single-member will be paid a reasonable salary like any wage earner and avoid paying self-employment tax.