6.05 – Offering Flexibility
Offering Flexibility: The S Corporation, the LLC & the Nonprofit Corporation
Various legal organizational forms offer flexibility for entrepreneurs in different ways. This lesson explores three such forms: the S Corporation, the LLC, and the nonprofit. All the criteria for choosing a legal structure apply to these forms as well.
Sizing Up the S-Corp
An S Corporation is a corporation that elects and is eligible for S Corporation status, with shareholder consent at the time of the election. Generally, an S Corporation doesn’t pay income tax. Instead, the corporation’s income and deductions pass through to its shareholders, who then report these on their personal tax returns.
An S Corporation can provide employee benefits and deferred compensation plans. To qualify for S Corporation status, you must:
- Form your corporation with no more than 100 shareholders, none of whom may be non-resident aliens.
- Issue only one class of stock.
- Ensure no more than 25 percent of corporate income comes from passive investments like dividends, rent, and capital gains.
Additionally, your S Corporation can’t be a financial institution, a foreign corporation, or a subsidiary of a parent corporation. If you change from an S Corporation to a C Corporation, you cannot revert to S Corporation status for five years.
S Corporations are ideal when:
- You expect to experience a loss in the first year or two, and owners have other income they can shelter with that loss.
- Shareholders are in lower tax brackets than the corporate rate, allowing profits to be distributed as dividends without double taxation.
- Your business may incur an accumulated earnings penalty tax for not paying out profits as dividends.
Comparing the S Corporation to the LLC
The Limited Liability Company (LLC) is a legal form of business organization that combines the best of partnerships (pass-through earnings) with the benefits of the corporate form (limited liability). LLCs are popular because they:
- Limit liability for business debts up to the amount invested.
- Offer a flexible management structure allowing members (similar to shareholders) or non-members to manage the organization.
- Allow the choice of being treated as a partnership with pass-through earnings or as a corporation, depending on which provides the lowest tax liability.
- Enable flexible distribution of profits and losses among members.
Differences between an LLC and an S Corporation include:
- An LLC allows an unlimited number of owners, whereas an S Corporation limits you to 100.
- An LLC permits non-resident aliens, pension plans, partnerships, and corporations as members, whereas an S Corporation doesn’t.
- LLCs can have different classes of stock, whereas an S Corporation generally is limited to one class.
Members of an LLC are similar to partners in a partnership or shareholders in a corporation. If members self-manage, they act more like partners because they have a direct say in organizational decisions. Ownership in an LLC is known as interest.
For long-term flexibility, an LLC is often preferred over an S Corporation.
Making Profits in a Nonprofit Organization
Contrary to popular belief, you can make a profit in a nonprofit organization; however, these profits cannot be distributed as dividends. A nonprofit (or not-for-profit) corporation is formed for charitable, public (scientific, literary, or educational), religious, or mutual benefit purposes.
Like a C Corporation, a nonprofit is a legal entity with its own life and offers members limited liability. Profits from nonprofit activities aren’t taxed as long as the organization meets state and federal requirements for tax exemption under IRS 501(c)(3). When forming a nonprofit, you give up proprietary interest in the corporation, dedicating all assets and resources to tax-exempt activities. If you dissolve the corporation, assets must be distributed to another tax-exempt organization.
Nonprofits derive revenue from various sources, including donations (which are tax-deductible for donors), fundraising activities, and selling services (a for-profit activity). Founders of nonprofit, tax-exempt corporations can pay themselves a reasonable salary, provide benefits, and operate similarly to a for-profit corporation—except for distributing profits.
