This article by Stuart L. Adams, Jr. appeared in the
Courier Journal Small Business Q & A
S Corporation vs. Limited Liability Company: New Rules and Decisions for 1997
(February 23, 1997)
Q: I want to start a small business which will have some liability issues. I have heard that a corporate structure may protect me better than a partnership. Ive also heard that an "S" corporation or limited liability company may be the way to go. How do I decide what is best for my business?
A: January 1, 1997 ushered in a new year and a revised set of choices for those entrepreneurs trying to determine the best choice of legal entity for their business. Changes in the rules for "S" corporations and for limited liability companies have made both types of legal entity more "user friendly" than they were previously. Both still have advantages and disadvantages for specific business and business owners. This is often an area where the entrepreneur, the attorney and the accountant should work together as a team to make the best decision, since the entity form can have long term impact on the success of the business.
When your attorney files articles of incorporation for you with the secretary of state, you are automatically a "C" corporation, which may be the best choice of entity for many business situations, but can result in what has been called a double tax bite. C corporations are taxed on their income at the corporate rate and the entrepreneur may be taxed again when the income trickles down to him or her.
Many small business owners may find it advantageous to elect "S" status. The "C" and "S" liability issue is essentially the same for most purposes. Starting in 1997, if there are 75 or fewer shareholders (counting a husband and wife and their estates as one) who are not disqualified (such as by being a nonresident alien) they may unanimously "elect" to be treated as an "S" corporation by filing a simple one page election (IRS form 2553) on or before the 15th day of the 3rd month of the tax year in which they seek the election to be effective. A late filing will simply become effective in the next tax year. In general, the S corporation does not pay any income tax. Shareholders report their income and expenses on their own tax returns, in proportion to their stock ownership, and are taxed at their individual rates.
S status may be automatically terminated if an event occurs which would have prevented the election in the first place. It may also be terminated or revoked by the consent of the holders of more than 50% of the outstanding shares. The effective date of the revocation is again based on a time frame similar to that of the election. Once terminated, however, S status may not be reelected, without IRS approval, until the 5th year after the year the revocation became effective.
Despite some new flexibility for S corporations starting in 1997, there are still a number of limitations which may make the entity less than desirable for your new company. One of those is the requirement that there be only one class of stock, not counting some differences in voting rights. Another is the prohibition of certain types of business entities as owners of shares. This may make financing through sale of shares less feasible in some situations. Fortunately, most states, including Kentucky and Indiana, have adopted legislation is recent years enabling the creation of limited liability companies.
A properly organized limited liability company (LLC) combines some of the better aspects of partnerships and corporations into one entity. Proprietorships and partnerships have no insulation from liability. By statute, the member of the LLC will typically have limited liability and no personal responsibility for the debts or liabilities of the entity or the other members. The individual LLC member will be taxed at partnership rates, and will not have to pay the double tax a C corporation can cause.
New IRS regulations went into effect on January 1, 1997, which eliminated much uncertainty in how the Service would treat the LLC. They may now be set up with much less paperwork and cost but greater security. You should still consider the issue of which entity is best for you, depending on the specific need of your business, including tax rates, liability, and treatment of the LLC or corporation as a matter of state law.
The LLC can be a wonderful estate planning tool, replacing the family limited partnership and the living trust, as well as many other devices. An LLC can allow you to rewrite the math of your estate through discounts the I R S has allowed in valuation challenges established over time. Several "discounts" are available to deflate the size of your taxable estate, including: minority interest in the LLC, which results in an inability to control the entity; lack of liquidity if the membership interest in the LLC cannot easily be converted to cash because the interest is subject to a transfer restriction, similar to a buy-sell agreement; and lack of marketability because the ability to sell the interest in the LLC is reduced by the closely held nature of the entity and the decreased likelihood of control or modification against the family interest. One or more of these may be tacked together to reduce the taxable valuation of an interest in the LLC from 100% of its pro rata value, down to something approaching 50% of such value in some cases.
Methods used to realize such discounts include setting up the LLC appropriately so that the senior members of the LLC retain control of the entity but breaking off minority interests and "gifting" them over time at greatly reduced rates to children, who will have neither control nor a majority interest until late in the plan. This can be an effective way to gift more than the $10,000 a year amount to a child by packing the LLC interest into shrunken bites and breaking up the estate to avoid the $600,000 Federal estate tax threshold.
All of these uses of a limited liability company deserve substantial consideration and expert guidance. The advantages and disadvantages of an LLC for a business or estate plan should be compared with those of other devices. The LLC, however, was designed to facilitate either conversion from another type of entity, such as a partnership, or merger with other forms. Given the extreme flexibility of the LLC entity, its inclusion of some of the best features of partnership tax rates and corporate type insulation from liability, plus its usefulness in estate planning, it seems prudent to look into its potential value to your business and your estate plan.