Some More on Limited Liability Companies (LLC) vs. ‘S’ Corporations

All other things being equal (for example, the accountant of my client is equally comfortable with the formation of an LLC instead of an ‘S’ corporation), I prefer the LLCs for small or start-up businesses. Both models of business organization provide limited liability and one level of taxation, at the individual level. The reason for preferring the LLC form is its flexibility. The Operating Agreement of an LLC sets forth the ownership interests of an LLC and defines the rights of the owners, or Members, (if specified, an LLC may be managed by non-owner managers) with respect to any and every aspect of the LLC’s operation.

An Operating Agreement for an LLC is an extremely flexible legal document. It can be tailored, almost without limitation, to accommodate different management duties between the Members, different voting rights, different membership economic interests, different past investments made or future investments due from or among the Members, different obligations or rights to participate in the business as a full-time employee, differing tax obligations or allocations, differing rights to lend to or borrow from the business, different repurchase or transfer rights, differing timing among members as to when or if distributions of profits are made, differing rights to convey interests to family members for estate planning – if you can think of it, you can draft it into an LLC Operating Agreement. The next week, if you want to amend the Operating Agreement, you do so with a simple addendum. Anyone or anything can own interests in an LLC, including another LLC.

‘S’ Corporations are simply not as flexible. Although the limitations on ‘S’ Corporations change from time to time because the ‘S’ designation is a federal and state tax election (and tax codes change), the fundamental structure of an ‘S’ corporation is still on the corporate model: the owners are shareholders and generally, there can be only one class of stock (no preferred shares, for example) held by the shareholders. The shareholders must elect directors (they can be the same people, but they wear ‘different hats’). The rules of management of the S Corporation are still determined by the codes that govern corporate management. The individuals who carry out day-to-day management of the business are the S Corporation’s officers: President, Secretary, Treasurer (who, again, may be the same people, wearing another set of ‘hats’).

There are limitations on the number of shareholders and many limitations on the types of entities which may hold shares. Although S Corporations certainly work in practice, and may have some tax benefits that LLCs do not, drafting By-laws for the ‘S’ Corporation and corresponding shareholder agreements is more time-consuming and less efficient, to achieve a unique, client-specified business objective, than drafting the LLC Operating Agreement. Moreover, because the ‘S’ designation is a tax election, changing tax codes or Revenue rulings or e.g., the death of one of the shareholders (who may have willed his shares to his niece, an non- U.S. citizen), may cause the ‘S’ designation to be in jeopardy, with adverse tax consequences. When you want to change ownership interests in any corporation, shares have to be transferred, either physically, or at least as registered on the corporate books.

Attorneys have dealt with the peculiarities of the ‘S’ corporation for years, but LLCs simply level the playing field with no loss of business efficiency. If the time comes that a corporate model is necessary, e.g., when the business grows to the point where venture capitalists are being solicited for new funding, then converting the business entity to another form is possible through a range of transformation options. If growing that large and that fast is the biggest problem that the business has, so that it must be converted to the corporate form (and probably incorporated in Delaware, an unnecessary expense for most small or start-up businesses), it is a good problem to have. In the meantime, while it is still being ‘incubated,’ a small business is better off opting for the flexibility of an LLC.