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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An Exit Strategy

When going into business, the last thing the owners want to consider is the demise of a partner or the business itself.  There’s an old proverb that says a partnership is easy to get into but hard to get out of (well, maybe it’s not exactly a proverb, but it has been said).  With that in mind, small business owners need to know how to get out of a business venture that is no longer working.  As with most things, the best way to do so is with advanced planning.  To that end, a buy-sell agreement is an important document for partnerships (and possibly LLCs and small corporations) to enter into when forming the company.

While buy-sell agreements can be substantial in scope, the agreement can and should provide for at least the following provisions:

1. A clause that requires a “forced” sell of the interests of a partner (member, shareholder) for major unlawful activity.  While minor offenses probably shouldn’t be included in this provision, felonies and/or offenses involving moral turpitude should be considered so the company can protect its good name.  Likewise, if it is a professional association, this clause could require the sale of the interests of an individual who loses his/her license.

2. A clause that allows a buyout of a deceased partner’s shares.  In some instances, however, the company may choose to not buy such shares.  In that event, the below provision should be incorporated.

3. A restriction of the voting interests in shares that are inherited by a third party.  Doing so ensures that a person not intended as a decision-maker for the company will not be thrust into that capacity.  In this instance, the owners of the shares would have “passive” ownership status.  They would be able to share in the profits of the company, but would have no decision-making ability.

Drafting a good buy-sell agreement will avoid numerous headaches in the future.  It is a highly recommended document for early-stage companies.

Dissolution of S-Corp

I was recently questioned on the liability of an S Corporation’s owners for taxes owed for a company that was dissolved.  Fortunately, there was a recent on-point IRS ruling addressing the issue.  The ruling held that the corporation’s S status did not terminate even though the corporation was administratively dissolved by the state of incorporation.  For more information, see http://www.mondaq.com/unitedstates/x/198708/Corporate+Tax/IRS+Rules+That+S+Corporation+Not+Terminated+By+State+Administrative+Dissolution

 

 

To LLC or Not to LLC

Over the past two decades Limited Liability Companies (LLCs) have become a preferred means of forming a business entity and with good reason.  LLCs provide their owners with many of the benefits of other types of entities while limiting their detriments.  In many instances, however, an LLC may not be appropriate, especially in early-stage technology or planned high-growth companies (often one in the same), who plan to go through several rounds of financing and, eventually cash out with a sale to a large company or an IPO.  The following is a brief comparison of oft-quoted reasons for establishing an LLC followed by counterarguments suggesting reasons to not set up this type of entity.

 

  1. Formation is quick and simple.  While Articles of Organization must be filed with the Illinois Secretary of State, the process is relatively painless.  The business owner should be prepared to answer some questions prior to organizing, including who the registered agent will be and whether the business will be “member managed” or “manager managed.”  The owner will also need names and addresses for the agent, the organizer, and the members/managers (in small LLCs, these can all be the same person).  The cost to file the Articles is $500.00 and there is an additional $100.00 fee for expedited filing.  In LLCs with 2 or more members, an operating agreement should be entered into, but this is not a requirement and is not filed with the state.  When the Articles are filed and approved by the state (a process that only takes about a day with expedited filing), the LLC becomes an official entity.

 

1a. LLCs may be difficult to invest in.   LLCs provide unique problems for investors that aren’t present in a corporate structure.  A member of an LLC who receives no cash distributions can still be taxed on the business income.  Venture funds often can’t (or won’t) invest in LLCs, especially if they have tax-exempt partners.  Furthermore, the relative simplicity of investment in a corporation via stock purchase is the preferred means of investment for early-stage growth companies.  Finally, LLCs are unable to perform some stock swaps that corporations can.

 

1b. Raising Funds.  Obtaining additional rounds of financing with a corporate structure is substantially easier than doing the same with an LLC. Tax issues can complicate matters when raising additional capital for an LLC that are not applicable in the corporate realm.

 

  1. The administrative burdens are light.  From a corporate governance standpoint, an LLC is not subject to nearly as many requirements as corporations.  There is no necessity to have a board of directors and, therefore, resolutions and written consents are not necessary for company action.  The only major on-going requirement is the filing of an annual report with the Secretary of State.  This is an important step, however as a failure to timely file the report can be grounds for administrative dissolution. 

 

2a. Difficult Agreements.  Although LLCs are easy to form and have substantial flexibility in the way they may be operated, this freedom actually poses a problem when the entity becomes complex.  While a small or self-funded LLC can get by with a basic operating agreement, a larger company (or one that plans to grow substantially) will need to spell out substantial terms in their agreements, making them unwieldy and a poor choice for a growing entity.

 

  1. Flexibility.  Substantially fewer formalities are required to manage an LLC as opposed to a corporation.  For example, an LLC can be managed by a “manager,” or by one or more “members.”  It can provide for a board of directors and employ officers, similar to a corporation, or it can simply be run by its member(s) or manager(s).  Distributions and allocations of profits and losses can be structured in different fashions in the operating agreement, as can the general operations of the business.  There are also few restrictions placed on who may be an owner of the entity and owners may be active in the day-to-day operations of the business.   

 

3a. Bias towards Corporations.  LLCs are becoming more common and knowledge of them is gaining, but major investors do most of their work with corporations and have a level of familiarity with that structure.  Therefore, even if the above issues are worked out, there is a good chance the documentation necessary for the LLC will be difficult for the investors and more time will be spent on due diligence prior to making an investment decision.  In the world of high growth companies, this extra time can spell doom for a company that needs quick funds to stay afloat.

 

  1. Limited Liability.  As the name implies, an LLC structure provides its owners with limited liability meaning that, while the company itself is liable for lawsuits and debts, the individual members (owners) are not personally liable.  While there is a way to “pierce the corporate veil,” most LLC owners can rest assured that their personal assets are safe regardless of what happens with the LLC. 

 

4a. No Argument.  Corporations were the initial vehicle to provide limited liability for their owners.  LLCs also have this benefit and, other than the veil piercing mentioned above, both entities are good choices for limiting personal liability.

      

  1. Tax Issues.  Corporations are generally subject to what is known as “double taxation,” meaning they are taxed on the income they receive and then taxed, again, when paying dividends to shareholders.  LLC’s, on the other hand, are considered “pass-through” entities, meaning that profits and losses are passed through to the owners and the LLC itself does not pay taxes on the gains, thereby avoiding double taxation.  Of course, the owners pay taxes, but when their tax rates are lower than the corporate tax rate, they will enjoy tax savings.  Furthermore, where the business expects to incur losses early in its existence, the members can claim the losses on their tax returns and obtain a personal tax benefit.

 

5a. Is Double Taxation Really a Problem?  As discussed above, LLCs are not subject to double tax.  However, this may not be an issue for many early-stage companies.   Therefore, the actual effects of double taxation may be overblown, as many early-stage companies trying to raise capital and grow quickly do not plan to be immediately profitable and have no profits and/or distributions to worry about.

 

 

 

Care should be taken in choosing an appropriate business entity.  While LLCs are a perfect choice for many start-up businesses, the particular plans of the company owners should be analyzed prior to making a commitment to business formation.

                                              

 

                                        

 

 

 

Buying or Selling a Business – Some Q & A

Why would you want to buy an existing business rather than start your own? For some, an ongoing cash flow is an attractive reason to buy. Another reason is a chance to grow an existing business more quickly.

Many people who buy businesses say that it is easier than a startup, although they may spend months scouting and researching a potential purchase. One thing is clear-researching the industry, the market and ultimately the company is key to future success.

Due Diligence

Once you get to the point of seriously considering the purchase of an ongoing business and have signed a letter of intent with the current owner, you need to thoroughly investigate all aspects of the business so there are no surprises once the transaction is complete.

What does “due diligence” actually mean?

Due diligence is the process of investigating a business to make sure that you have up-to-date, accurate and complete information that will later affect your operation of the business. This means verifying the seller’s statements and the business’s documents and records.

What is a letter of intent?

A letter of intent is signed by both the buyer and seller after most of the terms of the purchase are generally agreed upon. It shows that each is serious about completing the transaction and opens the way for the buyer to look more closely at the business records of the seller.

What if I am not familiar with all the regulations or if I do not feel very comfortable with all the bookkeeping and financial statements?

Even if you are on a tight budget, the time to bring in your lawyer and accountant is before you have written a check to the seller.

What should I look for when completing due diligence?

Here are some items you want to be sure to investigate when you are buying a business.

Paperwork: A good part of your due diligence time will be spent reviewing the company’s documents. This includes reviewing all financial records, such as income statements, balance sheets, cash flow statements, payroll, tax audits and a list of all physical assets owned by the company.

Other records, reports and contracts to study would include lease and loan agreements, any lawsuits past or present and insurance policies. Records of dealings with customers can give you valuable information, as will a thorough look at the company’s marketing materials-catalogs, brochures, Web site and sales letters, for example.

Compliance: If you were starting a company from scratch, you would need to research the registrations, licenses and permits required for the business. Ensuring compliance with local and national laws and regulations is just as important if you are buying a business.

Operations: You might want to roll up your sleeves and spend some time on the factory floor if you are considering a manufacturing facility. This is the time to talk with employees to get a better feel for the business.

You can check the company’s facilities with an eye toward safety and efficiency. Look at physical inventory and compare with corporate reports. Some potential buyers have been known to actually work at a company for several weeks before finalizing the deal.

Sales-current and potential: You have most likely studied and researched a potential purchase’s market and industry before you sign a letter of intent. Now that you have the opportunity to dig deeper, you can talk with suppliers and customers. You may be able to get a better sense of the competition.

I am selling my business. What due diligence should I complete?

As the buyer is studying the prospective acquisition, you should be studying the buyer. Of course you want to know if he or she can make the one or more payments called for in the contract. Even if the buyer is paying cash and you are retiring, you have an interest in maintaining a positive reputation for the business within the community.

The Small Business

People follow many paths to the point where they start their own business. For some, it is the American dream, a desire they hold all their lives. Others realize that they do not like working for other people-they just want to be their own boss.

Still others see themselves as pushed into going into business for themselves, perhaps because they have lost a corporate job they had always believed was secure. Some business owners start because they want a particular lifestyle, as might a mother who wants to work from home to be near her children. And then there are those who have the vision and drive to create a unique new product or service.

Whatever the reason for starting a business, many experts say that small businesses-which make up 99.7 percent of all employers in the United States-are a prime fuel of the American economy. And each of these business owners confronts a maze of decisions as they establish and move forward with their enterprises.

While there are virtually infinite ways to manage a business and an array of support services available, laws and regulations put boundaries on the choices that a business owner will make. If the business owner has a basic knowledge of the options, he or she can make smarter choices and avoid time-consuming and expensive problems.

One of the earliest decisions a potential business owner makes is how exactly to begin. Selecting a business that fits the owner’s personality, knowledge and resources is a step that usually takes both research and thought. Many people just assume that they will start a business from scratch. But others do not want to do so, and they decide to buy an existing business or a franchise.

In the coming months, we will look at numerous issues facing small business owners, entrepreneurs, and people who want to start their own business.

Introduction to Business Entities (Part 3)

Earlier posts analyzed several forms that businesses can take, including sole proprietorships, partnerships, and corporations.  This post looks at the most recently authorized form of business, the Limited Liability Company, or LLC.  While only available in Illinois for approximately the past 20 years, LLCs are the favored form of business for many small companies, as detailed below.

A limited liability company is an association whose characteristics are a combination of those of a corporation and a partnership. Unlike a partnership, an LLC is a separate legal entity from its owners. The owners are called members and have limited liability in that they are not liable for anything greater than their personal investment in the company. Members are not personally liable for the torts other members commit or any debts or obligations of the LLC.

Limited liability companies may be member-managed or manager-managed. The form of control is set forth in Articles of Organization which must be filed with the Illinois Secretary of State to establish the company.  No further documentation is required to form an LLC, but it is advisable to have an operating agreement, which provides details on the management and operations of the company. In a member-managed LLC, one or more of the owners will run the company. In a manager-managed LLC, the members appoint managers who will run the day-to-day operations of the company.

An additional advantage of an LLC is the flexibility it provides regarding taxation. Members generally elect “pass through” tax treatment (akin to a sole proprietor), thus eliminating any potential “double taxation” problems that corporations encounter.  Members can, however, choose to be taxed as a corporation in situations where that would be beneficial.

The flexibility LLCs provide their owners, the tax benefits, and the simplicity in establishing and running them are major benefits to this structure.  There are instances, however, when a corporate form is a better option and will be discussed in future posts.