Volume 3 Issue 5-- September/October 1999
In the previous issue, I discussed the development of the concept of Limited Liability Companies or LLCs, the new business kid on the block. Since this new business concept has not yet become a household word, my law practice still receives many calls from individuals who state "I want to form a corporation." In most cases, what they really mean is "I want to have limited liability from some business risks."
To begin the process of determining the best entity for a particular situation, the first step is to understand how they differ. The differences between an LLC and an S (flow through) corporation are shades of gray.
For example, usually, neither entity pays tax at the entity level, but they are subject to different sets of tax rules. So, how does one make the decision between incorporating or organizing an LLC?
Perhaps the best way to think of the difference between S and LLC is to say that LLCs are, in reality, partnerships with one very important attribute Lord Wadbottom's (remember him from last time?) cherished limited liability. While S corporations also have limited liability, they originated on the opposite side of the continental business divide.
S corporations are a creature of Federal tax law. When you form a corporation, most states, including Virginia, do not even need to know whether an IRS election is filed in order to have S corporate tax attributes (gain or loss) taxed at the shareholder level.
Because S corporations started as corporate animals, much of the baggage of corporate being carried over. For example, S corporations usually have shareholders, directors, minutes for shareholder and director meetings, and stock certificates. As in corporate law, shareholders' basis in their stock in the S corporation does not include any basis in loans to (or for) the entity.
LLCs, by contrast, come from partnership origins. When an LLC is formed, Articles of Organization (quite similar to articles of incorporation) are filed, and, in most cases, an Operating Agreement, which is nothing more (or less) than a partnership agreement, is prepared. Limited liability and statewide name registration are about the only things "corporate" with LLCs.
Is an LLC Operating Agreement needed for a one-person LLC, since sole proprietorships do not have anything akin to an agreement with the sole owner? In many cases, our office suggests not doing an operating agreement for a sole owner. In some situations, a lender or franchisor, for example, may insist that a one-person LLC have an operating agreement. Likewise, in other cases, an operating agreement could be valuable in addressing certain succession of ownership issues (i.e., what happens if the owner becomes incapacitated).
Many of the same considerations also apply to an S corporation. Is there a minute book, entity bank account, stock certificates, Federal Employer Identification Number, etc.?
In the next issue, we will consider the advantages of LLCs over S corporations as the subject relates to flexibilities in allocating profits, losses, deductions, and similar boring items.
Copyright 1999, Revised 2007
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