Corporation or Limited Liability Company: Which One is the Best for Your Needs?
Many entrepreneurs embarking on a new venture wrestle with the issue as to the appropriate entity through which to conduct their new venture. A great deal of information is available on the topic, varying in terms of its accuracy or depth of analysis. It is this author’s observation that in the minds of most business people and even in the minds of most attorneys, the LLC is almost universally the way to go.
This is not without good reason. The limited liability company offers some unique advantages in terms of its flexibility for structuring equity arrangements and management of the company. However, what is generally ignored with the knee-jerk choice of the LLC are some unique, but less obvious, advantages of the old standby, the S corporation.
Both entities are identical with respect to two very key features, namely, limitation of liability and tax flow-through treatment. Limitation of liability means that the business owner’s personal funds and assets cannot be used by a creditor to satisfy the debts of the business operated through the entity. Tax flow-through treatment means that the income of the business operated through the entity is not subject to a separate corporate tax. Rather, the income of the entity ‘flows through’ in that it is taxed on the owner’s personal tax return and taxed at the personal tax rates.
The limited liability company has a number of unique advantages when compared to an S corporation. First, the LLC always gets the benefit of tax pass-through treatment, whereas a corporation gets this benefit only if it files a Subchapter S Election with the IRS. Moreover, IRS rules relating to the Subchapter S Election limit the circumstances under which a corporation can make a Subchapter S Election. If a corporation cannot fit within these restrictions, it cannot achieve tax pass-through treatment.
Perhaps the most significant restrictions for the typical business are (i) that the corporation may not have more than 75 shareholders, and (ii) that the corporation can have only one class of stock. This latter restriction is significant in that it virtually eliminates any flexibility to distribute income and losses among equity owners on any basis other than in proportion to their ownership of the stock of the corporation. Thus, participants in a venture who wish to be more creative with allocating profits and losses of the venture must use the LLC to do so. For example, the LLC allows for (a) allowing some owners to receive income and cash flow earlier than others, (b) increasing the percentage of profits to one owner to account for a greater active participation of that owner, and (c) allocating losses to only to one member who may be contributing more money to cover initial losses. These results cannot be accomplished through the S corporation.
Second, corporations have a well defined, but fairly rigid, model for how the corporation is to be governed. That model is that shareholders have little active say in the operation of the business. Rather, they elect a board of directors, who have control over the major decisions of the corporation, including the election of officers, who control the day to day decisions of the business of the corporation. This model was created to accommodate the accumulation of capital to be deployed by large businesses run by professional managers. It generally works in a small business only by having the business owners wear all of the separate hats of shareholder, director and officer at the same time and maintaining the illusion that they are acting in different capacities under different circumstances.
The LLC structure, on the other hand, allows for almost unlimited flexibility in creating the mechanisms and rules by which the entity is governed and decisions are made among participants to a venture. This flexibility can be invaluable in structuring the financial and control aspects of the relationships among participants in a business.
Given these significant advantages of the limited liability company over a Sub S corporation, why ever use the corporation? First, for many businesses, the increased flexibility of that the LLC allows is simply unnecessary. For example, where the business is to be owned by one person, the flexibility of an LLC is irrelevant. Further, over recent years, the structure to govern corporations has become more flexible and much of the flexibility that an LLC offers in this area can be duplicated with a shareholder agreement.
Second, there are significant and unique advantages of the Sub S corporation. One advantage is cost. In Illinois, where the author practices, the filing fee and annual franchise taxes to operate an LLC are significantly higher than those of a corporation. Further, an LLC generally tends to cost a client more in legal fees to set up.
To understand why, it is helpful to think of the corporation as a mass produced item and the LLC as a custom made item. The corporation, having a fairly standard, but inflexible, model, can be set up quickly, using fairly simple templates.
The LLC on the other hand provides for a great deal of flexibility for parties to structure their operations by agreement, rather than pursuant to a structure created by a statute. Those agreements are reflected in an Operating Agreement. However, what this means as a practical matter is that a lawyer has to draft the Operating Agreement and each Operating Agreement is likely to be different and customized to the particular circumstances. Doing this tends to take more time, which results in higher fees to the client.
A second advantage relates to the self employment tax. In manager-managed LLCs, the managing members will usually be subject to self employment tax. In addition, a member of an LLC will usually be subject to self employment taxes if any of the following conditions apply:
1) The member has personal liability as a member of the LLC for the debts or claims against it, as when a member agrees to be responsible for LLC obligations such as a loan or lease;
2) The member has authority to enter into contracts on the LLC’s behalf; or
3) The member participates in the LLC’s trade or business for more than 500 hours during the tax year. In S Corporations, on the other hand, shareholder/employees are not subject to self employment tax on shareholder income.
.In conclusion, the limited liability company offers a number of significant advantages over a Sub S corporation. However, the Sub S corporation has certain unique advantages and in certain instances, the advantages of the LLC may not be relevant. Therefore, the Sub S corporation should not be automatically excluded from consideration.
Please feel free to contact the author at 312-948-8129 or ljdevries@devries-lawfirm.com
Circular 230 Disclaimer
In conformity with U.S. Treasury Department Circular 230 this document and any tax advice contained herein is not intended to be used, and cannot be used, for the purpose of avoiding penalties that maybe imposed under the Internal Revenue Code, nor may any such tax advice be used to promote, market or recommend to any person any transaction or matter that is the subject of this document. The intended recipients of this document are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this document.
