Choice of Business Entity – S Corporation or LLC?

As an attorney specializing in business organization, I have often been asked by my clients whether they should form an LLC or a corporation, specifically an S corporation. Well, that depends. In fact, it depends upon a lot. Most of my clients approach me already armed with the knowledge that either entity will generally shield them from personal liability for the acts and/or omissions of the business. However, relations between multiple owners, taxes and treatment of assets are just a few of the factors that will dictate which choice of entity is truly suitable for your business. By and large, there is no uniform "right" choice. A careful review of the details, strategies and goals of each business needs to be made before the entity is chosen.

There are, however, some basic similarities and differences between each entity. I have attempted to provide an overview of these key elements below. But please keep in mind, the information below, by itself, will not allow you to make a proper, informed choice of entity. This should always be done in conjunction with the assistance of your attorney and accountant.

C Corporation

Most large companies are C corporations. All publicly traded corporations are C corporations. The "C" designation comes from Subchapter C of the Internal Revenue Code, which governs corporate taxation. There are a variety of reasons C corporations are more aptly suited to large businesses. For example, multiple classes of stock, unlimited number of and types of shareholders, a fiscal year vs. calendar tax year and retention of corporate income to fund future growth are just a few of the key differences of a C corporation. Generally, this structure is desirable for businesses who seek to raise capital publicly, or whose investors are widespread.

Net income is reported on Form 1120 or 1120A and taxed by the IRS on a sliding scale starting at 15% for $0-50,000 in income, unless classified as a "personal service corporation" (PSCs are corporations whose shareholders are primarily engaged in the performance of personal services such as law and architecture). PSCs pay a 35% flat rate from dollar one of net profit, making this a generally undesirable entity type for PSCs).

Most importantly, C corporations are subject to double taxation. This means that all of the income of the C corporation is taxed once at the corporate level, then those same revenues are taxed again at the shareholder level when profits are distributed via dividends (please note that in smaller C corps., the double tax may sometimes be avoided by carefully zeroing out of net income each year by paying enough out to shareholder-employees). Shareholders must report any dividend earnings as capital gains on their personal tax returns.

Shareholders own the corporation by virtue of owning stock (or shares) in the corporation. Corporations issue stock certificates to its shareholders to indicate ownership percentage in the corporation. Under Illinois law, as every other State, shareholders of corporations generally enjoy a complete liability shield from the acts or omissions of the Corporation itself. The shareholders elect directors who manage the business and affairs of the corporation. Illinois law requires that a President, Secretary and Treasurer be named as officers of the corporation (Although sole-shareholder corporations are allowed under Illinois law). The Bylaws of the Corporation is its governing document. It typically governs the relationship between the shareholders, directors and officers. The Bylaws also specify voting rights and establish annual meetings of the shareholders and directors, among other items. In Illinois, all corporations must have a set of bylaws that govern the corporation (the law governing corporations in Illinois is the Business Corporation Act of 1983).

Finally, all corporations are created automatically as C corporations and then elect S corporation tax treatment after organization.

S Corporation

An S corporation is a corporation, just like a C corporation. Its shareholders enjoy the same general shield from personal liability for the corporations' acts or omissions.

The major difference lies in the tax treatment of the S corporation. As stated, C corporations are subject to taxation at the corporate level and the shareholders are then subject to taxation on that same stream of revenue when distributed in the form of dividends. By contrast, S-corporations avoid double taxation since only the individual shareholders are taxed. S corporation status is achieved by electing such tax treatment after organization (IRS Form 2553). Net profit or loss after expenses for S corporations, including salaries paid to employees and shareholder-employees, is reported on federal Form 1120S and "passed through" to shareholders' personal tax return via Schedule K-1, where it avoids payroll taxes and is subject only to ordinary income taxes. Additionally, pass-through losses are limited to the taxpayer's basis in the stock of the S corporation. Keep in mind, salaries of any shareholder-employees are subject to employment taxes in an S corporation. And IRS rules do require that reasonable salaries must be paid to shareholder-employees (the failure to do so is considered by many to trigger an internal audit).

Among other key differences, S corporations are less flexible than C corporations and LLC's. Only a limited number of shareholders, usually only individuals, and no foreign shareholders are allowed. In this sense, S corporations are typically more suitable for small and closely held businesses who do not seek to raise large amounts of capital publicly.

As with a C corporation, shareholders own the corporation by virtue of their stock in the corporation. They also elect directors, who in turn elect officers to operate the business and affairs of the corporation, just like the C corporation.

Limited Liability Company (LLC)

An LLC, or limited liability company, offers the same personal liability shield that a corporation offers. But, it provides significant flexibility in terms of the treatment of capital contributions and allocation of profits and losses to its owners. Specifically, an LLC can distribute profits in the manner its members see fit. For example, assume Joe and Charley own an LLC to which Charley contributed $80,000 in capital and Joe only contributed $20,000. If Joe performs 80% of work the owners could still decide to split the profits 50/50. If these same partners owned an S Corporation, Charley would be required to take 80% of the profit and Joe only 20%.

The LLC's owners are called members and each Member owns a percentage of the LLC by virtue of owning a Membership Interest in the company. Members can include corporations and other LLCs, providing ultimate flexibility in ownership structure with this entity. An LLC is usually Member-managed, where the business and affairs of the LLC are managed by the Members themselves, or can be a Manager-managed LLC where either a member-manager or an outside manager is appointed instead. Most small business LLCs are usually member managed. Like most if not all other states, Illinois allows single-member LLCs. Illinois also allows professional service providers, such as attorneys and doctors, to form LLC's for conducting their business, unlike many other states. The governing document of the LLC is the operating agreement.

Like an S corporation, an LLC is also a pass-through entity at the federal level. In other words, it is treated as a partnership for tax purposes with income reported on Form 1065 and then distributed to owners via Schedule K-1. However, single-member LLC's (including a married couple filing jointly) files a Schedule C. All profits and losses distributed to the members and any "salaries" (generally considered any guaranteed payments) paid to them are considered self-employment income and are subject to self-employment taxes. Owners of the LLC are considered to be self-employed and must pay a "self-employment tax" equal to 15.3%. Remember, in an S corporation, only the salaries and not the distributions to shareholer-employees are subject to employment taxes. Thus, the S corporation provides significant employment tax savings to its shareholders in contrast to the LLC.

LLCs provide limited liability protection in most instances if properly established and maintained, but usually few or no tax benefits versus a Schedule C sole proprietorship or general partnership exist. However, LLC's are usually the entity of choice for real estate ventures for a variety of reasons, primarily due to the tax treatment of real property.