Entity Formation: LLC or S-Corp

A common question when establishing a business entity for a small business in Illinois is whether it should be formed as a Limited Liability Company (LLC) or an S Corporation (S-Corp).  While S-Corps have a long history, LLCs are relatively new constructs, authorized in 1994 by 805 ILCS 180.  As LLCs have become a more recognized and viable entity over the past two decades, more companies are choosing to organize in this manner and forsake some of the difficulties imposed by the S-Corp form of business.  This post compares some of the major similarities and differences between these two types of entities.

A.       Major Commonalities

  1.  Organization:  Both are formed by filing an organizational document with the Illinois Secretary of State (Articles of Incorporation for the S-Corp and Articles of Organization for the LLC).
  2. Governance:  Both are governed internally by a specific type of organizational document (S-Corps use bylaws; LLCs use an operating agreement).
  3. Liability:  Both provide limited liability for their owners (owners of an S-Corp are called shareholders; owners of an LLC are called members )
  4. Tax Treatment:  Both receive flow-through tax treatment regarding federal taxes (however, differences may arise due to S-Corp being governed by Subchapter S of the Internal Revenue Code whereas LLCs are governed by Subchapter K of the Code).

B.       Major Differences

  1. Number of Owners:  Whereas LLCs may have any number of members, S-Corps may not have more than 100 shareholders.
  2. Types of Owners:  LLCs may have corporations, partnerships and other entities as members whereas S-Corps can (generally) only have individuals as shareholders.  Additionally, S-Corps may not have nonresident aliens as shareholders; LLCs do not have a similar restriction.
  3. Governance:  Unless registered as a close corporation, S-Corps are managed by directors and officers, not the shareholders; LLCs, on the other hand, may be run by managers, directors, officers, the owners, or a combination thereof.  S-Corps must adhere to strict governance procedures, or risk what is known as a “piercing of the corporate veil” in which the owners may lose their limited liability protection.  For example, the failure to hold regular director meetings may be cause to hold the owners personally liable for the company’s obligations.  Outside of filing an annual report with the Secretary of State, LLCs have very few formal governance requirements.
  4. Tax Treatment:  While both entities have the ability for flow-through tax treatment, there are potentially significant differences (for example, an S-Corp may not get flow-through tax treatment if it was previously converted from a C-Corp or if it has excessive net passive income for three consecutive years; conversely, LLCs may be subject to self-employment taxes and may potentially lose its flow-through status if it is classified as a “publicly-traded entity.”

Conversion from an S-Corp to an LLC?

In reviewing the above, one may come to the conclusion that a company previously formed as an S-Corp would be better served by converting to an LLC.  While this can be done in most instances, there are tax and other considerations which must be taken into account.  Furthermore, there are numerous situations where an S-Corp may actually be the better entity.  Early stage technology companies are a prime example of an instance where the corporate form of organization is better than an LLC.  Upcoming posts will address other forms of organization for businesses.

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