Business Entity Selection – S Corp or LLC?

Law news | April 2, 2020

Business Entity Selection – S Corp or LLC?
As an Illinois attorney who often helps business clients form the entities under which they operate their various businesses, I am often asked whether they should form a limited liability company (“LLC”) or a corporation, specifically an S corporation (“S corp”). Many clients know that unlike partnerships or sole proprietorship’s, LLC’s and S corps are entities that will generally shield them from personal liability for the acts and/or omissions of the business. However, relationships between owners, management responsibilities, tax treatment and profit and loss allocations are just a few of the factors that will dictate which choice of entity is right for their business. Generally, 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 some of the key elements below. It is important to keep in mind, the information below, by itself, will not allow you to make a proper, informed choice of entity for your business. This should always be done in conjunction with your attorney and accountant.

Pass-Through Entities:
S corps and LLC’s are similar in that both are “pass-through” entities for tax purposes. The income generated from these companies is passed through to their members or shareholders as the case may be, thereby eliminating the double taxation incurred by owners of a standard corporation, or C corporation. In this regard, both S corps and LLC’s are both preferable over a C corp as a C corp’s profits are taxed once at the corporate level and then again when the remaining profits are distributed as dividends to its shareholders who must then pay income tax on the dividends.

There are no limitations on who can be a member (i.e. owner) of an LLC. Any individual or entity can be a member of an LLC. Only individuals, other than non-resident aliens, certain estates and trusts, single member LLC’s, charitable organizations and qualified retirements plans can be shareholders of an S corp. Thus, an S corp cannot have as a shareholder a nonresident alien, a corporation, a partnership or a multi-member LLC as a shareholder. Additionally, S corps are also limited to no more than 100 shareholders, while LLC’s have no limits as to the number of members it may have.

Allocations of Income and Losses:
An LLC, which is taxed like a partnership, provides significant flexibility in terms of the treatment of capital contributions and the allocation of profits and losses to its members. Specifically, an LLC can allocate profits and any losses in the manner its members see fit, as long as they have a substantial economic effect. Shareholders of an S corp however must allocate and distribute profits and losses in proportion to their stock ownership percentages. Each share of an S corp must be treated the same as every other share in this respect

The management of an LLC can be by the members or the members may elect to have a manager run the day to day operations of the company. Conversely, the shareholders of an S corp elect directors who oversee the affairs of the corporation and have responsibility for major decisions. The directors in turn elect officers who manage the daily affairs of the business.

There are a myriad of other important similarities and differences between S corps and LLC’s which are beyond the scope of this article. In addition, with any business where there may be multiple business partners, strong consideration should be given to entering into an agreement to govern the rights and obligations of the parties. With a corporation, this agreement is referred to as a shareholder’s agreement and with an LLC the agreement is referred to as an operating agreement. Again, prior to starting a new business, you should first consult with both your attorney and accountant, professionals who can more fully explain the important factors to be considered to ensure the entity you are choosing best fits your business model.