It’s a common question I get. Do I want to be an LLC? Do I want to set up as an S corporation, or do I want to set up as a corporation? The answer truly depends on the company and your needs and your wants and your future plans. There is no one answer. One is not better than the other. What we have seen is an emergence of the LLC as being a clear choice to be reckoned with. Several years ago, we would not have had a discussion about LLC versus corporation because many people were scared to use the LLC form. That is no longer the case.
Case law from the courts has clearly made it known that the LLC will be respected in many cases, so we don’t have to worry about that. What we do need to worry about is, what is the best structure for a given company in a given situation. Let’s just run through each form of entity and some of the pros and cons of each to help you with your decision making.
Let’s start with LLCs. LLCs are very flexible. They really are a combination of corporations and partnerships, two different legal systems that have been combined into a new paradigm called the LLC. The LLC has been around for quite some time. What it blends is the freedom of contract. You can set up an LLC agreement any way you want with limited liability that business owners so frequently desire. In many cases, it’s the best of all worlds. The LLCs pros are the flexibility, the potential limited liability if done correctly, the ability to blend things the way you want, and the ability to really make the company yours and reflect your management style and your way of running the company.
The Cons of the LLC include there are not a lot of defaults in the statute so if you have a problem, you need to fall back to your LLC agreement. If you don’t have a robust LLC agreement, you’re going to be ending up in a system that was set up by somebody else. Also, because they’re so easy to set up, a lot of people make mistakes. Just because they’re easy doesn’t mean you don’t have to do anything, and many people miss important steps in setting up and establishing their LLC. Another con is that some investors just don’t like LLCs. There are still some funds out there and some larger investors that prefer corporations over LLCs.
Let’s look at corporations. Corporations are the old standby. They’ve been around for quite some time and they are well known. They have a set structure for management that locks in things being done a certain way. Some of the pros of the corporation include the set structure makes it simpler to set up a corporation, in some ways. Now there’s more paperwork typically than an LLC, the structures already set so you don’t have to spend time and energy documenting how the structure works. Corporations are well known and well respected, people know what a corporation is and it helps you get business done. Sometimes in international transactions, a corporation is more recognized than an LLC because they’ve been around longer.
Some of the cons of a corporation include the structure that works so well for some people is also rigid and doesn’t give a lot of flexibility to the business owners. Also, the corporation is much more difficult to set up with investors and veto rights and other items like that. So, to make it do very particular things in a very particular way a corporation is harder to work with than an LLC.
The S corporation is a sister of the C corporation. Basically, you take a corporation or even an LLC and you elect to be taxed as an S corporation. There are certain requirements for being an S corporation dictated by the IRS such as having all US persons as stockholders and a certain limited number of stockholders. You have to make sure you are qualified for S chapter treatment. What the S chapter treatment does is it changes the entity to a flow-through entity for income tax purposes rather than having two levels of taxation. Typically, a corporation is taxed at a corporation level and then the dividends are sent out, those are taxed at the shareholder level. S corporation eliminates that. There’s just one layer of tax at the shareholders level. You can see a pro here in many cases.
Also, for tax purposes S corporation recognizes the difference between ownership and participation in the business whereas an LLC is typically a flow-through entity. The tax rules generally blend the payment for the ownership services and their profits for being a business owner. With an S corporation, you can do a better job at splitting these two revenue streams. Clearly, between the owner, we have a real benefit here in many cases.
You will have to document that you are paying fair compensation in the S corporation cases which one of the potential downsides is the ability that structure challenged by the IRS. In many cases when people are setting up an LLC with flow through taxation it would make sense to use an S corporation.
What other issues are you seeing out there? What other questions do you have about these structures? Let us know so we can structure future content. Are you struggling with this choice and why? What are your particular issues? Join us in the comments below and let us know about your thoughts and experience.
This posting is intended to be a tool to familiarize readers with some of the issues discussed herein. This is not meant to be a comprehensive discussion and additional details should be discussed with your attorneys, accountants, consultants, bankers and other business planners who can provide advice for your circumstances. This article should not be treated as legal advice to any person or entity. Freeimages.com/Photographer Abdulhamid AlFadhly.
About the Author
Shawn McBride — R. Shawn McBride is the Managing Member of The R. Shawn McBride Law Firm, PLLC. Shawn works successful, private business owners in their growth and missions to make a company that stands the test of time. You can email R. Shawn McBride or call (214) 418-0258.
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