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Choice of Entity: Corporation (C or S) or LLC?

By Douglas Drushal

March 15, 2016

 The landscape of making the choice of entity for a new business venture has changed dramatically over the course of my legal career. In the pre-Cambrian era when I started into this line of work, most new entities were Corporations, relying upon a) the well-established, centuries-old structure and b) limited liability for investors, provided by this entity.  The phrase "limited liability" simply meant that an investor, who became a shareholder, had the invested dollars at risk but other personal assets not at risk. 

Individuals often did business in their own name as a Sole Proprietor.  There was an occasional General Partnership thrown in when two or more persons wanted to form an entity and wanted something simpler to create and operate than a Corporation, and an even more infrequent Limited Partnership which allowed some (not all) owners to have limited personal liability. 

This list of choices worked reasonably well, as the Corporation form allowed for alternate taxation structure of either a "C" Corporation (which is its own taxpayer) or an "S" Corporation (which files a tax return but its income or loss is passed out to the tax returns of its shareholders).   Essentially all Partnerships shared the “pass-through” taxation feature of an S Corporation but all partners had complete personal liability for all obligations of the Partnership (except for limited partners in a Limited Partnership).

There was (and is) no significance to the letters C or S, as those are merely the subchapters of the Internal Revenue Code in which the respective sets of laws are found for these two types of corporations.  But the tax laws applicable to both types of Corporations can be quite complex, and Congress imposed strict limits on the ownership and operation of S Corporations. 

You will notice no mention of a Limited Liability Company (commonly called LLC) above because in the "old days" they were not permitted under the law of any state and literally did not exist.

            This world had a revolution, one state at a time, when some clever people, initially in smaller states but eventually in every state, came up with the idea of the LLC, which has the limited liability protection for its owners of either type of Corporation but the pass-through taxation advantages of an S Corporation or Partnership.  As such, since the 1990s, when LLCs became available in Ohio, this choice of entity has been preferred in almost all contexts and I have created very few corporations for nearly twenty years.

            So today, in a very simplified summary (with some exceptions, after all we are lawyers!), there is only one situation in which a Corporation is a preferred business entity.  That one situation is where a small number of owners (perhaps just one) will also be employees of the entity and they can pay themselves a fixed salary (wearing their hats as employees) and take out the rest of the profits as corporate dividends (wearing their hats as shareholders).  Only the salary portion of their overall earnings will be subject to Social Security tax, thus saving approximately 15% (combined employee and employer FICA taxes) on the amount of earnings above their salary but below the maximum wage subject to FICA tax.  This is not a huge savings, but it can be material in the limited set of circumstances in which this applies.

            In the absence of this FICA tax savings scenario, and assuming there is no plan of the entity becoming a large publicly traded entity, there remains essentially no benefit to forming a Corporation.  This is why the overwhelming majority of new entities today are LLCs.  And because LLCs are so easy to form and operate, creating a General Partnership virtually unheard of today, given the unlimited personal liability for owners of General Partnerships.

            While one can obtain both limited liability and pass-through taxation with an S Corporation, the limitations on eligibility and the complexity of S Corporation taxation make S Corporations much less attractive than LLCs.  Features of Corporations such as preferred stock, liquidation preferences, transferability of ownership, buy-sell agreements, options and the like are all available in an LLC.  A possible desired feature of a C Corporation is the fact that it is not a pass-through taxation entity and thus company earnings can sometimes be taxed at lower corporate rates, but even this feature is available in an LLC by simply having the LLC elect to be taxed as a C Corporation.

            What I have outlined here is greatly simplified and there are nuances which still must be considered, depending upon the long-term goals of the investors establishing a new business entity.  While a lay person can easily create the entity itself, or use an on-line service provider’s assistance, understanding the nuances require the skill of an experienced team of lawyer and accountant.  But this brief article provides an accurate summary of the landscape of choice of entity in today’s legal climate.

           

 Doug Drushal, a senior Member of CCJ, has nearly 40 years of experience in business formation, as well as the buying and selling of businesses of all types and sizes.  Contact Doug at ddrushal@ccj.com for more information or to discuss your situation.

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