Answering the "LLC vs S Corporation" Question

Stephen Nelson
December 18, 2008 — 2,638 views  
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Entrepreneurs and small business owners sometimes struggle with the "limited liability company versus an S corporation" question. But that's unfortunate. The question is (sometimes) very straight-forward to answer...

The Answer is Always "LLC"

If someone really, truly has a choice between a limited liability company and an S corporation, or Subchapter S corporation, the business can and should be operated as an LLC.

Here's why: A Subchapter S corporation isn't actually a real corporation. Rather, an S corporation is a tax accounting classification that's available to a variety of entities, including regular corporations, limited liability companies, and several other possibilities, too.

This reality--the fact that an S corporation is really a tax accounting classification--simplifies the decision if someone is trying to choose between an LLC and an S corporation. You can select the limited liability company option in this case. Why? Because you can elect to have the limited liability company treated for tax purposes as an S corporation.

To elect Subchapter S corporation tax accounting treatment, you file a 2553 form with the IRS. Some states (including Pennsylvania and New York) require their own separate state S election.

One quick aside: If you don't make an S election for an LLC, the LLC gets treated as "something else" for income tax purposes. A limited liability company with multiple owners, or members, gets treated for tax purposes as a partnership, for example. And a limited liability company with a single member is treated, typically, as a sole proprietorship.

But "LLC vs S Corp" Question May Be Wrong to Ask

An important point needs to be made about the whole "limited liability company vs. S corporation" question, however.

Sometimes, what people are really asking is whether a new business should be formed as a limited liability company or as a regular old-style corporation. In other words, the right question may be "LLC versus corporation."

As mentioned earlier, both LLCs and corporations can make an election to be treated as an S corporation. Accordingly, the decision to form an LLC is totally disconnected from the S corporation election. But there are still reasons to incorporate...

A Good Reason to Incorporate

Probably the best argument for a regular, old-style corporation is that stakeholders (like customers, employees or vendors) expect a corporation rather than a limited liability company.

Sometimes this preference for a corporation flows from a feeling that a business with the name "Acme Incorporated" just seems more solid than a business with the name "Acme LLC."

However a caution is in order here: Many entrepreneurs use a corporation rather than an LLC because they don't know enough about LLCs. The preference for a regular corporation may indicate the entrepreneur lacks sophistication.

Reasons to Choose LLC Formation

Finally, it's important to note that as compared to a regular corporation, LLCs offer up some big benefits.

For example, one big benefit already hinted at concerns the tax flexibility of an LLC. A limited liability company can be treated as a partnership, a sole proprietorship, a regular corporation, or an S corp.

A common tax planning technique with LLCs is to keep things simple in the beginning by operating as, for example, a sole proprietorship. Then, after the business is running along profitably, an S election can be made. This flexibility is unique to a limited liability company.

Another big benefit of the limited liability company concerns the safety of the ownership interest. As a general rule, shares of stock in a corporation can be seized by creditors of the shareholder. In other words, if some shareholder goes bankrupt or gets sued, that shareholder's shares will probably end up in some other person's hands.

In many states, however, member interests in a limited liability company can't be seized. Rather, the best an outside creditor can do is get a judge to order that money the LLC disburses to the LLC member go instead to the creditor. These orders, called "charging orders," mean than a business or investment owned via an LLC is actually much safer in many cases than a business or investment owned via shares in a traditional corporation.

Note: Why the LLC membership interests can't be seized is beyond the scope of this short article, but the rationale is that LLCs should be treated as partnerships and the law can't force people to become partners.

About the Author

Seattle tax accountant and author Stephen L. Nelson taught the "LLC versus S Corporation" taxation class at Golden Gate University's graduate tax school. Nelson also edits the http://www.llcsexplained.com/ and http://www.scorporationsexplained.com/ web sites.

Stephen Nelson