CONSIDERING FORMING A SMALL BUSINESS (Part II)? IS AN LLC OR S-CORPORATION RIGHT FOR YOU?

Even the most brilliant innovators and entrepreneurs require protection, but from what you might ask. The answer is actually suggested by the question itself, and is quite simple: you just don’t know. You never really know all of the things that might present themselves as potential liabilities, real or imagined, against you and your company. To the extent possible, one of your first goals as an entrepreneur is simple: shield your interests, corporate and especially personal. Exposure is everywhere, and everyone’s looking for certainly against that risk. While nothing is an absolute guarantee, there are nonetheless a myriad of ways to protect your individual interests, all the way from umbrella insurance policies to corporate formations. The latter serves as the fodder for today’s article.

While virtually everyone’s heard of a corporation and a limited liability company, practically speaking, not many understand the differences between them and which is the right choice for their particular business. Truth be told, even professionals sometimes differ on these opinions. Attorneys and CPAs have a notorious reputation, rightly or wrongly, for recommending a different entity selection to the same client. Is one suggestion necessarily right or wrong? I guess that depends on whether you’re speaking with the attorney or the accountant. Regardless, whenever considering the formation of a business, one should consult with a trusted advisor to ensure the right choice.

With all of that said, I’ll use the balance of this article as a primer on some of the primary similarities and differences between corporations and LLCs. In particular, given that we’re talking about start-ups, this article focuses on S-corporations rather than C-corporation. For a more detailed discussion of the difference between S and C-corps, feel free to review my prior article which addresses that issue. Now, on to the discussion at hand..

1. Formality and Liability Shield: Let’s start with one of the primary reasons that individuals form a legal entity to conduct business in the first place – the creation of a business shield. Both corporations and LLCs provide their shareholders/members with liability against corporate liabilities. There are really only a couple of caveats to that rule. Regardless of whether you’ve chosen a corporation or an LLC, each entity has certain formalities that must be strictly adhered. If you fail to abide by those formalities, you risk the entity being set aside, and the courts recognizing that you are personally liable for the corporate liability at issue. Aside from adhering to corporate formalities, unless the owners engage in egregiously fraudulent and intentional acts under while acting in the name of the business, the courts will honor the shareholders’/members’ liability shield.

2. Membership Size: If the potential number of members in the business is a concern to you, either in terms of your intentions to grow the business later on or who you may want to bring in as a member, here are a few other considerations. S-corporations are limited to no more than 100 shareholders, and all shareholders must be United States citizens or permanent residents. If your business is facing circumstances that might circumvent either of those restrictions, then your s-corporation could lose its status and revert to becoming a C-corporation. Such being the case, LLCs might be your best alternative if you expect to face either of those possibilities.

3. Pass-Through Versus Double Taxation: Both S-corporations and LLCs are considered pass-through entities for tax purposes. What does this mean in practical terms? Unlike C-corporations that face taxes on not only the corporation itself, but on the earnings paid out to the corporation’s owners, the company profits of S-corporations and LLCs are only reported on the personal income tax returns of the businesses’ respective shareholders or members. In this way, members of S-corporations and LLCs avoid that dreaded “double taxation” that so many fear when forming traditional C-corporations.

4. Income and Loss Allocation: On the related issue of taxes, another significant difference between S-corporations and LLCs comes in the form of income allocation. LLCs are often a favored entity because of the flexibility they allow their owners, especially when it comes to income allocation. Quite distinct from S-corporations, where shareholders incur income and losses subject strictly to their pro-rata shareholder interest in the business, income and loss between members of an LLC can be disproportionately allocated among its owners. Regardless of what each member puts in to the business, they can nonetheless enter into any sort of allocation agreement they might like vis-à-vis the operating agreement. The members will then be taxed accordingly by the Internal Revenue Service.

5. Membership Levels: Here’s just a quick note on the availability of differing membership classes in S-corporations and LLCs, but one nonetheless worth making. As far as S-corporations are concerned, shareholders own only one class of stock, which are either voting or non-voting shares. They cannot however have distinctions like common stock and preferred stock. Non such limitations exist relative to LLCs where you can have different membership classes with different priorities and preferences.

These are only some of the many important features that align and distinguish S-corporations and LLCs from one another. When you’re considering starting a new business, it’s critical to have a firm grasp on all aspects of the entity differences to ensure an appropriate choice, so always consult with a qualified professional to assist with your decision.