Recently I appeared on an “Ask the Lawyer” panel for home and small office business operators. One question of universal interest was: which is the preferable type of business entity for a new enterprise–corporation or limited liability company (LLC)? My answer to this question is the standard one I learned in law school: “It depends!” This is not meant to be coy or cute. There are numerous considerations which will influence the decision. This article is not an exhaustive discussion of the pros and cons of each business format, but highlights some of their more salient features.

First and foremost, talk to your accountant. The nature of your business and the number of anticipated owners are critical elements. In terms of tax consequences, expectations as to income and payment of salaries, dividends or distributions are highly significant. Other items to consider are retention of earnings, choice of fiscal year and medical insurance, to name a few.

One purpose for incorporating or forming an LLC is to protect personal liability in the event of a lawsuit, in which case the damages would typically be limited to the assets of the entity. Another purpose is to obtain certain tax benefits such as deduction of expenses.

Corporation: There are basically two types: a C corporation and an S corporation. One person or closely held corporations often elect an S-corp because of the pass through of earnings and losses to the owners, like a sole proprietorship, without the “double taxation” on dividends of a C-corp.

An S-corp, also referred to as a “Sub S,” is regulated under Subchapter S of the Internal Revenue Code. An election form must be filed in order to procure this status. There is a limit on the maximum number of shareholders (100) and they must be US citizens. Earnings, whether or not retained, are deemed income to the shareholders.  A major benefit of the S-corp is that the shareholders may take a “reasonable” salary and then take non-taxable distributions, i.e. not subject to self-employment tax.

Depending upon the circumstances, a C-corp may be preferable to an S-corp because the marginal corporate tax rate for a C-corp may be lower than one’s individual tax rate. Also, medical benefits may be deducted and earnings may be retained.

LLC: An LLC, like an S-corp, provides limited liability for the owners and the earnings pass through. An LLC is not a corporation, but an entity organized under state law. It has ultimate flexibility in that it can be structured as a partnership or a corporation. The owners are “members” who hold “units.” A major disadvantage to an LLC is that self-employment tax  may apply to each active individual member’s share of the profits unlike the non-taxed S-corp distributions.

Which is easier to establish and maintain? Again, that depends.

Costs: An LLC is more expensive. If you incorporate or organize in Illinois, the fees are substantially different– LLC: $500 vs Corp: $175. Illinois also requires an annual filing. Minimum fee: LLC: $250 vs Corp: $100.

Taxes: Employees of both are subject to withholding taxes. Forms W-2 and Forms 1099 must be used as appropriate. Income tax returns required to be filed are: C-corp: Form 1120; S-corp: Form 1120S. LLC: If one member who is a person: 1040; If more than 1 member: a partnership return, Form 1065 with K-1′s issued to each member, or the LLC may elect to be taxed as a corporation. An EIN # is required of all except for a single person LLC who files a 1040.

Registered agent: This is the in-state person or company appointed to receive service of process of legal documents as well as the state annual report forms required of both types of business entities.

Documents: For a corporation to be a properly documented, bylaws and corporate minutes are required. The bylaws are typically standard. The annual meetings of shareholders and directors can be easily handled by an “action” by the majority of shareholders or directors in lieu of a meeting. The documentation can be standardized and updated every year.

An LLC which has more than 1 member should have an operating agreement. This can be a complex, comprehensive and costly document to have prepared. The LLC statute does not have the requirement of annual minutes. However, the operating agreement may require such and where there are multiple owners, company business actions should be documented and approved as a matter of good business practice.

Regardless of the business entity chosen, protection against personal liability is not absolute.  One factor the courts look at is the compliance with the formalities. Therefore, shareholders and owners should always make sure to document the significant company business decisions and activities and that they have been approved by the requisite majority.

In summation, the choice of business format for your company can have significant tax consequences. It is possible to convert from one type of entity to another, but that could involve substantial costs, so it is preferable to do it correctly from the beginning. Please be sure to consult with professionals before embarking on this important step.

Jan S. Weinstein
Jan S. Weinstein & Associates, Ltd.
Attorneys at Law
9933 Lawler Avenue
Suite 402
Skokie, IL
847/933-9890
847/933-9880 – fax
jan@jsweinsteinatty.com