Choosing a Proper Business Form for Your Small Business: Limited Liability Companies vs. S Corporations

As a business owner, limited liability should be one of your primary concerns. With limited liability, an owner’s personal assets are safe from the suits against the business entity. The advantage of limited liability is a clear reduction of risk on the part of an owner or shareholder. Historically, limited liability was available only in the corporate form. Along with limited liability, the corporate form also brought the oft dreaded prospect of double taxation—the imposition of tax once at the corporate level as the gains accrued and again at the individual level when income was distributed.

However, many business forms now offer the protections of limited liability without the additional level of corporate tax. How then does a prospective small business owner who desires limited liability but not corporate taxation choose a business form that is right for their business? The right decision can only be made after considering a combination of business and tax implications in light of the business goals and circumstances.

Two common business forms that offer limited liability and different formational flexibility—or, in some cases, inflexibility—are the Limited Liability Company (LLC) and the S Corporation (S Corp). The pros and cons of the two business forms are discussed by this article to orient the reader with the considerations that should be made before electing to use either of these business forms.  You should consult with an attorney to discuss how these benefits and liabilities may apply to your individual situation.

Business Formalities

In general, the S Corp follows more business formalities than does the LLC. Dealing with formalities can be a hassle to a small business owner but can also be an advantage in certain circumstances.

S Corps require various formal writings and filings, including articles of incorporation, corporate bylaws, annual reports, an S Corp election, and recorded minutes of mandatory annual corporate meetings. This stands in contrast to the LLC, which does away with most all of the traditional corporate requirements. The LLC requires an operating agreement among the members (members being the name for owners of an LLC, a rough equivalent of shareholder in a corporate). The operating agreement has flexibility that allows members to agree upon structure and rules, much like basic contract negotiation. LLCs do not require corporate meetings with minutes, but both forms must file annual reports with the Secretary of State.

From the standpoint of a sole proprietor or a very small number of owners, compliance with these S Corp formalities may not be the right choice. On the other hand, the extra red tape and writing requirements can have at least two advantages. First, it is evidence of clear distinction between the people who run the day to day operations of the corporation and its owners. A separate life between the corporation and the owners decreases the chance that a court would “pierce the corporate veil”, thereby nullifying the benefit of limited liability. Secondly, more formality and annual minutes can help limit misunderstandings and resolve conflict among owners down the road. Defined bylaws and records of meetings are avenues to resolution should a dispute among owners go so far as to enter litigation, and in fact could lead to resolution before ever reaching litigation.

Organizational and Operational Restrictions

Much like its emphasis on business formalities, an S Corp is more rigid than an LLC in its organizational structure. An S Corp may only have up to 100 shareholders and may only have one class of stock. This means that preferred and common stock distinctions are impermissible under the S Crop form. However, it is permissible to have voting and non-voting stock in an S Corp. Furthermore, only individuals may be shareholders in an S Corp, and those individuals must be either US citizens or permanent US residents.

On the other hand, an LLC has no restriction on class of ownership. Foreigners may be members of an LLC, and ownership is not limited to individuals—partnerships, corporations, estates, or other entities may be members of an LLC. Once again, the LLC has more flexibility in its form than does the S Corp.

However, the LLC does have restrictions that the S Corp does not have. To safely maintain tax status as a partnership—with flow through taxation, as discussed below—the IRS requires the LLC not have more than 2 of 4 “corporate” characteristics: (1) continuity of life, (2) centralization of management, (3) limited liability, and (4) free transferability of interests. Although having 3 or more corporate characteristics does not automatically disqualify the LLC from partnership tax status, there will be an undesirable degree of uncertainty about the tax status. Furthermore, many states, such as Illinois, require that a date or event of dissolution be specified. Therefore, continuity of life is not available to an Illinois LLC, whereas an S Corp can theoretically survive into perpetuity.

Allocation of Income and Loss

In general, both the S Corp and the LLC are pass-through entities, meaning that loss and gain—and the resulting tax implications—are assigned at the individual owner level, not the entity level. However, how gain and loss is allocated is restricted more in the S Corp form than in the LLC.

The S Corp is rigid in its allocation of gain and loss because all gain and loss must be allocated according to a shareholder’s pro rata share. That means if a shareholder owns 20% of the shares of the corporation, 20% of all gain or loss is assigned to that shareholder.

On the other hand, the LLC allows for disproportionate allocation of gain and loss. So long as the LLC has substantial economic effect (for tax purposes), disproportionate allocation through the operation agreement is allowed. For instance, a 30% percent owner could be allocated 40% of gain and only 20% of losses.

Taxation

Tax implications, is also an area to be considered when choosing a business form. For both the S Corp and the LLC, the pass-through nature of gain and loss allocation means that owners must be prepared for “phantom income,” that is, taxation on allocated gains that are still inside the entity and not in the individual’s immediate possession. In the S Corp, the taxable gain or deductible loss will be in accordance with a shareholder’s pro rata share. In the LLC, the taxable gain or deductible loss will be in accordance with the operating agreement, so long as the operating agreement has substantial economic effect. In general, the LLC is treated as a partnership by tax laws, whereas the S Corp is taxed in accordance with Subchapter S of the Internal Revenue Code, from which the S Corp derives its common name.

It is important to note that different states treat S Corps differently. Some states may not recognize the S Corp election, taxing the S Corp as a C Corp, the traditional dual-tax corporate form. Others, like Massachusetts, may tax S Corp profits over a certain level. Still others, like New York and New Jersey, may tax both the S Corp profits and the individual shareholder’s shares. Illinois does not currently impose income tax on S Corps; the taxable gain of the S Corp is paid by shareholders as part of their individual incomes based on their pro rata share.

Conversion to C Corporation

As a passing note, many venture capital firms eventually will want C corporation status. It is much easier to convert from an S Corp to a C Corp—it requires only filing of a tax form—than to convert from an LLC to a C Corp, which requires a merger of the business entities. If C Corp status is a foreseeable business transition for you, the S Corp form can make the eventual transition much smoother.

Summary

Below is a table listing some of the major similarities and differences between S Corps and LLCs. Both forms of course offer limited liability for their owners without the additional level of corporate taxation.

S Corp LLC
Must follow business formalities, including filing articles of incorporation, writing bylaws, appointing a board of directors and corporate officers, filing annual reports, and holding recorded meetings Few business formalities; the operating agreement controls and is negotiated for among the business owners
May issue only one class of stock (although voting and non-voting stock is ok); no more than 100 shareholders; shareholders must be people and cannot be foreigners May have as many classes of stock as agreed upon; no member number restriction; members can be entities or foreigners
Unlimited life of corporation Limited life in most circumstances (required to have date of dissolution in IL)
Gain and loss allocated to shareholders according to pro rata share of stock Gain and loss allocated to members according to the operating agreement; default is pro rata share of ownership
Taxed under subchapter S of IRC; shareholders taxed on S corporation’s income each year Generally taxed as a partnership; members taxed on LLC’s income each year


Conclusion

This article is merely a summary of various traits of LLCs and S Corps that a prospective business owner should consider and this article should not be construed as legal advice. Before undertaking an entrepreneurial endeavor, it is always best to consult an attorney. We at Rock Fusco & Connelly have the necessary experience counseling and litigating to help clients create and protect their businesses.

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