For the closely-held business, choosing a business entity under which to operate used to be easy. The proprietor usually operated as a sole proprietorship, a partnership, or as an S Corporation. There were clear advantages and disadvantages to each one. The sole proprietorship and partnership had the advantage of simplicity and lack of formal arrangements. The S Corporation was for those individuals needing asset protection and a formal entity in which to operate.
Today the choice of business structure is not so easy. Generally, the use of sole proprietorships and general partnerships is very limited to home based businesses. Currently, most business people have the choice between operating as a Limited Liability Company or as an S Corporation. When deciding which entity to operate under, the business owner must take a lot into consideration. This month, we will focus on the comparison on the Subchapter S Corporation versus the LLC from the perspective of a business owner looking at the newer of the business entities, the Limited Liability Company.
The Limited Liability Company
An S Corporation does have restrictions on ownership. First, in order to hold an S Corporation status, a stockholder must be a resident and citizen of this country. Second, no more than 100 people are allowed to own the stock of an S Corporation at any one time. If the ownership requirements are violated, the company will lose its S Corporation status and it will not be allowed to hold S Corporation status for a number of years.
With an LLC, these restrictions (citizenship and limit on number of shareholders) do not exist and its status is not jeopardized. While most LLCs will maintain membership of well under 100 members, the option to expand the number of investors rapidly, does exist. Many immigrants just starting business can benefit from this form of business. On the other hand, a business owner, operating as an LLC has the advantage of looking to non-citizens as investors, yet increasing selling potential.
There are fewer formalities in maintaining an LLC as opposed to an S Corporation. This is a major convenience and aides in limiting tort and contractual liability; however, the LLC and S Corporation are both potentially subject to being disregarded as an entity if the owner does not obey statutory formalities. This process of disregarding the entity in court is what is known as “veil piercing”. Generally, it happens when company owners do not observe formalities such as annual meetings, failure to elect officers, record meetings, keep paperwork, and otherwise use the business as an “alter ego”.
The advantage here is that the LLC does not require as many statutory formalities as S Corporations. Hence the LLC can be a better insulator against liability if the occurrences of meetings and production of documents is going to be an issue.
Shares of an LLC are easier to put into a trust than an S Corporation. To put shares of an S corporation into a trust, special language and provisions must be used. It can be somewhat complicated and LLCs tend to work very well instead of S corporations for the purposes of trusts in transfer, estate, and business succession scenarios.
During operation of an LLC, profits are taxed only at the shareholder level, the same as an S Corporation. Profits from the operation of the business “flow through” to the income statement of the owner. This does not mean distributions are taxed immediately; the income (revenue minus expenses per the tax return) of the LLC is taxed to the owner. This can be a significant disadvantage if the LLC does not pay out distributions. Owners can find themselves facing large tax bills without the cash to cover it if the LLC has large profits, yet regular distributions are not made.
When winding up the affairs of the entity and dissolving, gains are taxed once. Nearly all businesses will eventually close their doors. Both the LLC and the S corporation offer the owners the chance to close the doors and be taxed only once on the sale of the assets.
Limited Liability Companies are becoming more popular. This is because most business owners want a limit on liability, single layer taxation, want to limit the formalities and still enjoy the protections. The LLC is definitely worth consideration, next month we will look at the issue from the vantage point of the proprietor looking to operate as an S Corporation.
By: Dr. Bart Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors