We are often asked the question of whether to establish a new company in the form of a corporation or limited liability company. This is a very complex question, involving many factors, including anticipated tax and growth issues. Therefore, you should always consult with your particular advisors.
As a general rule, our office follows some guidelines for general discussion:
Corporations and LLCs are legal entities with presumed limited liability protection for the shareholders. However, the corporate entity has a tried and true existence for many years and, all things being equal, remains our entity of choice. Corporations offer great flexibility and protection. Corporations are the entity of choice to "go public" in an initial public offering. Corporations also offer tax qualified stock options (ISO's).
Corporations have the detriment of "double taxation"; that is, for $100 of profit, the corporation pays an income tax, then the remainder that is distributed to shareholders is taxed again to the recipients. This is effectively like being in the 55% tax bracket. For smaller businesses, a corporation and make a Subchapter S election. This tax election, called an "S" election, or S corporation, allows the corporation to be taxed similarly to a partnership. Partnerships themselves do not pay taxes, but the income "flows through" the corporation and is taxed directly to the partners at their personal tax rate, on a pro-rata basis relative to ownership of the partnership. S corporations offer the best of both worlds: limited liability and taxation like a partnership.
The downside of an S corporation is that it is limited to one class of stock, 75 shareholders, no non-resident alien shareholders, no corporate shareholders under certain circumstances. Usually, it is the one class of stock and corporate shareholder issue that presents challenges for structuring.
LLC's are technically historically partnerships with limited liability. Therefore, LLC's are taxed as partnerships, unless you prefer otherwise. As the same time, LLC's do not have the long legal history such as corporations. LLC's have only been recognized as legal entities in more recent years. And, for many years, taxation of LLC's was in dispute. Therefore, the case law relating to taxation and governance is less assured. Unlike the LLC statute, the corporation statute has much more definitive rules, and a long history of case precedent.
Where LLC's perform best is when an S corporation will not work because flexibility is required in structuring, such as two classes of stock. However, because LLC's permit such great flexibility, care must be taken in the structuring. A blank slate can be a good thing or bad thing, depending upon the circumstances. LLC's present excellent opportunities for joint ventures.
That said, here's a common thought process:
a. A single resident shareholder. No plans to have corporate shareholder. No need for multiple classes of stock. No fancy structuring. A simple small business desiring limited liability. We often recommend S corporations.
b. Any time an S corporation will not be available and the flow through tax is desired, then we often recommend an LLC. If the client has the goal to become a public company, then it is a trade-off between a C corporation or temporarily an LLC until the IPO.
We know of some firms that recommend LLC's for all purposes because of the corporate and tax flexibility. We do not share that perspective. LLC's are very flexible entities for structuring, but, if the flexibility is not needed, then the LLC creates risk, particularly for a single member LLC. S corporations have, of course, worked splendidly for many years.
In short, we start with the soft presumption of forming limited liability entities in the form of S corporations, then evaluate the particular circumstances of our client to determine if we should override the presumption for an LLC.
[IMPORTANT NOTICE: Articles are for general information only. Laws vary in jurisdictions. You should not rely upon this information for your particular situation. The law in this document may not be current, and jurisdictions vary. Always consult an attorney for your particular situation.]
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