S-Corporation or Limited Liability Company
If you are in the process of starting a business, you may be debating what business entity will best meet your needs or you may have just assumed that the corporation is the best entity because a corporation will limit the "owners" personal liability for the obligations of the corporation. Even though a properly maintained corporation will generally insulate its shareholders from personal liability, organizing your new business as a corporation may not necessarily be the best choice. The limited liability company, for example, may better suit your long-term needs since it not only provides limited liability, but also offers flexibility with respect to management and profit sharing.
Deciding which entity to use for a new or existing business can be a daunting task. Typically, the business owner must consider the business, legal and tax issues. These considerations will often translate into a cost analysis, but performing the analysis can be extremely difficult even for the most experienced professional. Generally, the analysis breaks down to three key issues: (1) limiting the tax burden; (2)
limiting the potential liability of the owners from the perceived business risks; and balancing the two with (3) the business owners' unique circumstances. Similarly situated businesses may have different objectives. For example, while the primary goal of one business owner may be to avoid personal liability for the liabilities of the business, another business owner may be more concerned with tax consequences. For this reason, the goals of the prospective business entity should dictate which business entity is chosen.
It is therefore essential for the business owners to ask what are the primary objectives of the business before forming the business entity. Typically, the major factors that should be considered by the business owner include: 1) the ease of formation; 2) the number of owners; 3) the desired management style and control; 4) the authority of owners and management to bind the entity; 5) the owner's liability for business obligations; 6) the desire for easy transferability of the owners' interest in the business; 7) the desire to raise capital; 8) various tax considerations; and 9) the ease of dissolution, in the event things go badly.
The remainder of this article will outline the main characteristics of the corporation and the limited liability company (LLC).
The corporation is a separate legal entity with a perpetual
existence that offers limited liability protection. What does this mean? Well, this merely means that the owners (shareholders) will not be held personally liable for the debts and obligations of the corporation solely because they are owners. The C corporation is also a separate taxpaying entity, but it may elect to be taxed as a sub-chapter S Corporation.
The S corporation passes the income earned, or losses incurred, by it directly through to its owners (shareholders). Unlike the C corporation, however, the S corporation cannot own any subsidiaries, it cannot have corporate shareholders, the number of shareholders permitted is limited to 75, and it can only have one class of stock - preferred non-voting shares are not permitted.
What The Corporation Offers
1. Limited Liability Protection. The owners' personal
exposure to the potential liabilities of the business will be minimized if the corporation is properly organized and maintained.
2. Formation. While formation of the corporation is easy (filing of the Articles of Incorporation with the Secretary of State), there are a number of formal requirements that must be adhered to just after formation, including: the election of directors, appointment of officers, the adoption and preparation of by-laws, the issuance of stock, the filing of various other documents on an annual or bi-annual basis, and the holding of annual shareholder and director meetings. Notwithstanding these formalities, the corporation is still much easier to form and organize than a limited liability company (discussed below) because with a corporation there is no need to negotiate a detailed agreement covering the structure and operation of the organization.
3. Centralized Management. The corporation is managed
through the Board of Directors. The Board of Directors will appoint officers to run the day-to-day business operations. Shareholders (the owners) elect the Board of Directors, but have no right to participate in the day-to-day management of the corporation, unless elected as a director, or appointed as an officer. The officers are considered the agents of the corporation, and neither the shareholders nor directors have the authority to bind the corporation (only the officers).
4. Transferability. Ownership of the corporation, which is evidenced by share certificates) can generally be easily transferred.
5. Ability to Raise Capital. Generally, capital is raised through equity contributions by the shareholders, loans from shareholders, and secured and unsecured loans from third parties.
Unless the corporation is structured as an S corporation, the corporation and its shareholders are subject to double taxation. First, the corporation pays federal and state taxes on its income at the corporate tax rate and is not allowed to deduct the dividends issued to its shareholders. Second, the shareholders then pay tax on the dividends they receive from the corporation. This double taxation, however, can be minimized (e.g. paying salaries to shareholders and/or implementing
shareholder loans). In addition, the corporation offers the ability to lower and defer income taxes on profits and the ability to use tax losses to offset future gains.
A qualifying corporation organized as a "S" corporation can avoid this double federal taxation by having its profits, losses and tax credits skip taxation at the corporate level and pass directly through to the shareholders.
7. Perpetual Life and Dissolution. Unlike the limited
liability company, which can have a designated life (generally 30 years), the corporation can last in perpetuity until affirmatively dissolved, by filing dissolution papers with the appropriate state agency.
The Limited Liability Company
Both the LLC and the S corporation, if properly formed and
maintained, offer limited liability protection and pass-through tax treatment. While the LLC is generally more difficult to properly form because of the need for a detailed Operating Agreement, is a much more flexible in terms of structure and management and less burdensome in terms of local and state reporting requirements than the corporation.
The Main Characteristics of the Limited Liability
1. Limited Liability Protection. Just like the corporation, the owners' personal exposure to the potential liabilities of the business will be minimized if the limited liability company is properly organized and maintained.
2. Formation. To form the LLC, the individual must first file Articles of Organization with the Secretary of State, and in some states a Statement of Information. The members of the LLC must also enter into an Operating Agreement, which should be as comprehensive and detailed as possible. As a result, the corporate entity wins when it comes to ease of formation.
3. Flexability. The LLC is probably the most flexible entity choice in terms of management and structuring economic sharing arrangements among the owners. The LLC can be managed by either its members (member-managed LLC) or an elected centralized management team (a manager-managed LLC). In addition, where one owner agrees to contribute all of the cash needed for the business, and another owner agrees to contribute services by operating the business on a full-time basis, the parties might want to structure a preferred cash-on-cash return to the money
partner. This can be easily done with an LLC, but would be very
difficult to accomplish with an S corporation.
4. Transferability. Like the corporation, transferability of a members interest can be easily accomplished so long as the Operating Agreement permits such a transfer. With an LLC, however, the Operating Agreement can be drafted to easily permit a member to transfer his or her economic interest, but require formalities or restrict the ability to transfer the voting and management rights associated with that
4. Raising Capital. Capital is raised through capital
contributions from members, loans from members, and secured and unsecured loans from third parties. If seeking capital, the corporation will more easily facilitate equity and capital financing arrangements because nearly all investors are familiar with the issues and documentation associated with investing in a corporation.
4. Formalities. The LLC is less formal than both the C and S corporation. The LLC is not required to follow the strict procedures to which corporations must adhere. Annual meetings of the members and/or managers, however, while not required are strongly recommended.
Tax. Some of the positive tax treatment that can be achieved in a corporate setting are unavailable when dealing with a LLC, and owners of a LLC may find themselves subject to a number of tax burdens that could have been avoided under the corporate structure. However, the
are significant tax advantages if the primary purpose of the LLC is to own real estate.
Despite some of the negative tax aspects and the higher formation costs, the LLC has become the premier entity choice among smaller business people. Why? Because it offers a clear definitive outline of the business and how it is to be operated and managed, how profits and expenses are to be shared, how a withdrawal or dissolution is to occur, etc... and unlike the corporation does not require continuous formalities to be adhered to for the members to maintain limited liability protection.