A Comparison of the Limited Liability Company and the S-Corporation

Authored by
Julia K. O'Neill and David H. Feinberg

Let's say that you and two of your colleagues come up with a plan to start a new business. You think you should form either a business corporation that makes an S-corporation election (an "S-Corp.") or a limited liability company (an "LLC"). But you do not know which.

This article describes some of the similarities and differences between the two.

In many cases, you will want to organize the entity in the state in which you will operate your business. If you are planning on seeking investments from outside professional investors, you should probably organize the entity in Delaware, because outside investors are most comfortable with Delaware entities. The filing fees in Delaware are fairly low. Keep in mind, however, that you will also need to qualify your entity to do business in the states where you operate.

You know you need an entity which will protect the principals from any personal liability for the business's debts and obligations. Either an S-Corp. or a LLC will provide this protection, assuming formalities are followed and no circumstances lend themselves to a creditor's being able to "pierce the corporate veil." Effective representation by counsel and observation of basic corporate formalities should prevent creditors from ever piercing the corporate veil.

You also want an entity whose income will be taxed to the principals on a pass-through basis, such that there is no tax at the entity level, but only at the individual owner level. Both the LLC and the S-Corp. are taxed in this manner, although in some states the S-Corp. must pay an annual minimum excise tax to the state. For example, in Massachusetts, every S-Corp. must pay a minimum excise tax of $456 to the Commonwealth. And in Massachusetts, if an S-Corp.'s annual receipts exceed six million dollars, the entity could become liable for substantial state income taxes. The LLC is not liable for any state excise tax in Massachusetts.

You want to restrict transfer of your equity interests, so as to ensure that only persons who are actively involved in the business can own equity. You also want to provide for purchase of a deceased or disabled owner's share by the entity or the other owners. Both the LLC and the S-Corp. lend themselves easily to these arrangements. The LLC's operating agreement can include these restrictions on transfer and buy-sell provisions. The shares in an S-Corp. can be made subject to such provisions by their inclusion in the Articles of Organization or other organizational document or by contract.

The structure and functioning of the S-Corp. are governed by statute. In general, the shareholders elect the directors, and the directors name the officers. The officers run the day-to-day operations; the directors make decisions that are out of the ordinary course of business; and the shareholders make the most material decisions, such as whether to sell all or substantially all of the corporation's assets. There are many more rules contained in each state’s statutes which govern the S-Corp. and which are often not optional or modifiable on the part of the shareholders or the company.

The LLC, however, is much more flexible. The statutes allow for a great deal of leeway in selecting the method of governance of the entity. If the owners wish, they can make one person a manager with all the authority in the world (almost). An LLC does not have to have any officers or directors. The entity can be set up, operated and terminated any number of ways. There is a myriad of choices available to persons forming an LLC.

Although flexibility can be a bonus, it carries with it a certain level of complexity which some people would rather avoid. The flexibility that comes with an LLC necessarily involves decision-making which some may find daunting.

If you think your business will ever take in funds from venture capital or other institutional investors, you will probably be better off with a corporation from the start. Otherwise, you may have to convert from an LLC to a corporation. Many venture funds and institutional sources of funding are structured as pass-through tax entities themselves and have off-shore investors or 501(c)(3) entities as limited partners. These funding sources seek investments in corporations, not LLC’s, because the off-shore investors do not want to be taxed in the U.S. (which they would if the fund invested in a U.S. pass-through entity) and because the 501(c)(3) entities do not want to realize unrelated business taxable income (again, which they could realize if the fund invested in a pass-through entity).

If you anticipate that your business may end up being sold in a stock-for-stock transaction, you should either structure the business as a corporation so that you can easily take advantage of tax-free reorganization rules, or you should be sure that you convert your LLC into a corporation before you first contemplate a sale – that is, before you even have a term sheet or initiate conversations with a potential acquiror. Undoubtedly, you would be very unhappy if, in five years, you sell your company for illiquid stock in a corporation but have to pay taxes on the value of the stock you receive, even before you can sell the stock. The only way to avoid this tax result for an LLC is to convert to a corporate form before even contemplating a sale.

On the other hand, if you think that your "exit" will involve an asset sale and you do not anticipate raising venture capital or other institutional funds, you almost certainly should organize your entity as an LLC. No matter how much more complicated an LLC may be than a corporation, it will be worth it if you save 30% or so of the proceeds of the asset sale because, unlike a corporation, there is no double taxation of asset sales for an LLC.

Another major difference between the LLC and the S-Corp. relates to the number and type of owners or members. There are no restrictions on how many members an LLC may have or who they may be - e.g., individuals, corporations, or other entities. The S-Corp. may have as few as one shareholder but no more than 100 (husband and wife are treated as one), and they must meet certain criteria. They must be individuals, estates, certain types of trusts or certain exempt organizations, and they may not be nonresident aliens. The S-Corp. can only have one class of stock (although differences solely in voting rights are allowed). The LLC can have many different types of equity interests in one entity.

In addition to the differing treatment of taxation upon a sale of your business, there are some more technical tax issues which should be considered in deciding whether to form your business as a corporation or an LLC.

One tax aspect to consider is that the income of an LLC that flows through to persons involved with the business will generally be subject to self-employment tax. With an S-Corp., only salaries are subject to self-employment tax. If other income is paid out as S-Corp. distributions, it will not be subject to self-employment tax. (Note in this regard that the IRS has broad authority to recharacterize income as it sees fit.)

A second tax difference between the two entities is that, in an LLC, distributions of appreciated property will generally be tax free, and the members will have a carryover basis in the distributed assets. Not so with an S-Corp. Distributed appreciated assets will cause shareholders in an S-Corp. to have taxable income and take a basis of current fair market value in the assets. This is the major reason why conversion from an S-Corp. to an LLC creates tax issues, while conversion from an LLC to an S-Corp. generally does not.

A third, and major, tax difference is that in the LLC, generally owners can have different allocations of tax benefits like depreciation and losses, without regard to their pro rata ownership interests. The S-Corp. cannot make special allocations of these tax items.

Some states may have tax traps for the unwary with respect to one type of entity or the other. For example, in Massachusetts there is a major tax problem for LLC's which are in a business that carries inventory. The personal property tax statutes specifically exempt personal property of domestic business corporations, but not of LLC's. This means that an LLC with substantial personal property (e.g., inventory such as automobiles) will be liable for property tax for which the business would not have been liable had it been formed as a corporation. This type of legislative omission could be a costly trap for some businesses.

The LLC is generally preferable to the S-Corp. where the entity will own real estate subject to substantial debt, because the LLC provides the benefit of member-level tax basis adjustments for LLC liabilities and the allowance of an adjustment in the tax basis of the entity's assets upon the sale of a member's interest. The S-Corp. shareholder cannot include any part of the corporation's debt in the tax basis of his stock, unless he loaned the money to the corporation. Because of these differences, LLC members are able to deduct more of the entity's tax losses as they occur than S-Corp. shareholders.

Different circumstances may point to a choice of one type of entity or another. There are always pros and cons to both choices. But being aware of the differences and similarities between these two types of entities will help you make the right choice.

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