Choice of Business Entity - S Corporation or LLC?
By Philip Nicolosi
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.
Mr. Philip A. Nicolosi provides legal services throughout
northern Illinois concentrated in the areas of real estate
law, business law, business organization and commercial transactions.
Mr. Nicolosi is the owner and operator of P. A. Nicolosi,
Ltd., a Rockford, Illinois area law firm.
Mr. Nicolosi is a 1998 graduate of the University of Iowa
and received his J.D. in 2002 from Northern Illinois University.
Mr. Nicolosi is also the President and Managing Broker of
Nicolosi Realty Co., a fully integrated commercial real estate
company serving northern Illinois. Nicolosi Realty Co. provides
an array of services including brokerage, consulting, project
oversight, lease/LOI negotiation, site feasibility and use
analysis.
Please visit http://www.panicolosilaw.com for more information
regarding the services provided by P. A. Nicolosi, Ltd., and
Mr. Philip A. Nicolosi, or contact phil@panicolosilaw.com
Article Source: EzineArticles.com
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