Meeting Your Company's Needs
and Exceeding Your Expectations

Does Your Company Need To Be an LLC? 

While limited liability companies (LLCs) are now widely used to organize small businesses, there are several questions which should be answered prior to establishing a limited liability company: Are LLCs being overused? What advantages do LLCs offer small businesses versus the traditional S corporation? Do these advantages justify the considerable expense, complexity and uncertainty inherent in using LLCs as business entities? The fact is, that in most circumstances, the S corporation is actually a better choice since the advantages inherent in an LLC are not applicable to many smaller companies.  

Evolution 

Comparing the advantages of an the LLC with those of an S corporation is a continually changing proposition. For example, the interstate activities of an LLC outside of its home state used to be a major area of uncertainty and risk. Now, operating an LLC is less risky as changes in the law and recent court decisions  are starting to clear up the ambiguities which haunted LLCs in the past. Also, lawyers and the public at large are now more familiar with LLCs and how they function.

Similarly, in recent years some of the limitations of the S corporation have been relaxed allowing more shareholders to participate (up from 35 to 75 in 1997 and up to 100 in 2005).  

As of 1996, the types of entities that an S corporation may own, without terminating its S corporation status, has expanded. 

However, certain characteristics and problems associated with each entity remain (and probably will remain) largely unchanged. The LLC will probably always be more complicated because of its flexibility, multiple options and its taxation as a partnership, rather than as a corporation. It will probably continue to be more expensive with higher legal fees, state filing fees, and tax compliance issues. In turn, the S corporation will probably always have the major disadvantage of permitting only one class of stock   

LLCs and S Corporations vs. General Partnerships and C Corporations 

LLCs and S corporations share two major advantages over general partnerships and regular C corporations. First, both have limited liability: that is, their liabilities are largely (but not exclusively) limited to the company’s assets, while the owners’ personal assets are largely (but not exclusively) protected from those liabilities.  

Second, both entities enjoy single-level or pass-through taxation on income and capital gains; the entities themselves usually pay no federal and (in many states) no state income taxes. Instead, the taxes are paid by the owners on their personal income tax returns. (In contrast, general partnerships, sole proprietorships and C corporations each offer only one, but not both, of the two features of limited liability and single-level taxation.)

LLC Drawbacks

Most smaller businesses seldom encounter situations where the advantages of an LLC outweigh its disadvantages. These drawbacks include:

1. LLCs are still strange and unfamiliar. Many small business owners are still not familiar with LLCs, which were introduced in the mid-90s. LLC documents are quite different from corporate documents which have been around for a much longer time.

2. LLCs are complicated. The main document of any LLC, the operating agreement, is often 15 to 30 pages long and tends to be complicated. Moreover, most LLCs are taxed under the  partnership taxation rules, one of the most complex areas of tax law.

3. LLCs are more expensive to form and operate. Because of its length and its options, the  LLC operating agreement requires more choices and more time and effort, resulting in higher legal fees than those charged to form an S corporation. The state filing fees are often much higher, too. For example, in Massachusetts, the filing fee to set up an LLC is $500.00 (versus $275.00 for a corporation), while filing the annual report costs $500.00 (versus $125.00 for a corporation).

4. Some key areas of LLC law are still uncertain. There has been considerable concern about the LLCs’ limited liability and the powers and protections the LLC provides outside of its home state. There are many parts of the LLC statute which the courts have not interpreted. Key questions have yet to be answered: Do LLC members or managers have fiduciary duties to other members? Do minority owners have the same protections against oppressive majority owners that S corporations and other corporations enjoy? When will all states recognize the LLC as a single-tax entity, and tax it accordingly? 

LLC Benifits 

Distinct advantages which an LLC (taxed as a partnership) can offer (but an S corporation cannot) include:  

1. LLCs can have more than one class of stock. LLC owners can be given differing rights and interests in  the company without losing the pass-through or single-level taxation feature. In contrast, if significant variations in shareholder rights exist in an S corporation, multiple classes of stock will be considered to have been created, and  the S corporation’s single-taxation feature will be destroyed.  

2. LLCs allow less than 80% of new owners to contribute property without being subject to taxation on the transfer. In contrast,  the new shareholders of an S corporation must own at least 80% of the corporation to avoid taxation of contributed property.

3. An LLC allows greater freedom in building multiple-level corporate structures, and permits corporations to be stockholders without jeopardizing the single-level taxation feature. An LLC can be owned by a group of corporations (or other LLCs) and not lose its tax flow-through feature. This structure can be useful in forming business buying groups, joint ventures, or insurance agency clusters. In contrast, neither a corporation nor an LLC can be a shareholder of an S corporation without destroying the S corporation’s single-level taxation feature.

4. An LLC can convert to an S corporation without adverse tax consequences, but an S corporation cannot do the reverse without serious tax problems.

5. In family or other internal buy-out situations, certain types of payments made to the departing owner of an LLC can be partly tax deductible to the LLC, but are not deductible to an S corporation.   

6. Business loans to an LLC can increase an owner’s tax basis, which increases the owner’s capacity for deductions and lessens the tax on a sale of an LLC interest. The S corporation offers no such advantage. 

7. An LLC allows one to move appreciated property more easily into and out of an LLC without paying a tax. It is much harder to do so with an S corporation.