One of the common questions arising among new business owners pertains to limited liability companies and subchapter “S” corporations: what do they do? Do I need to have one?
The most basic function of either a limited liability company (LLC) or a subchapter “S” corporation (S Corp) is to segregate the business assets of the individuals owning and operating the business from their personal assets. The basic concept is the same whether we are talking about a small motorcycle repair shop or Ford corporation. If I buy 100 shares of Ford corporation for $1,000, I place at risk the amount of money spent in buying the shares. If Ford goes belly-up, I’ve lost my investment – but if Ford also has millions of dollars of unfunded pension liabilities, even though I am a shareholder and (in a tiny percentage) an owner of the company, I have no obligations for those pension liabilities. My business assets and investment (the $1,000) may be gone, but my personal assets are not. My liability is limited.
When you organize an LLC or S Corp, you are doing the same. A (fictitious) legal ‘person’ is created by filing with the Pennsylvania Department of State. You place money, time and energy at the disposal of the business. The business holds those assets in its name (not yours). The business has its own EIN (tax ID) number, which is not your personal social security number. The business has its own checking account. Generally, if the business fails, or is besieged by its creditors, or is the subject of a major lawsuit, you can avoid personal liability. There are some exceptions to the rule, and it doesn’t mean that you can’t be sued personally (anyone can be sued for nearly anything, at least until a proper answer or objections are filed and ruled upon by a court) – but once set up and maintained in a reasonable fashion, the attempt to collect against your personal assets should not be successful.
Do you need this protection? Suppose you have insurance? Very small businesses (and very lucky bigger businesses) get by just operating as a ‘sole proprietor’ – in the name of an individual with all his or her assets at risk. But you can’t easily protect yourself against certain types of unfavorable business events (e.g., a major customer doesn’t pay you – one of your employees steals – your subcontractor has an workplace accident and doesn’t have workers compensation insurance, etc.) General liability insurance can be useful, but insurance policies have numerous exclusions, deductibles and policy limitations, which often are not appreciated until you have to make a claim. No substantial business owner wants to take these risks if they are avoidable.
LLCs are simple and easy to form, but they need to have an operating agreement (something like a partnership agreement) prepared to declare who owns the LLC. S Corps are a little more expensive and cumbersome, but in certain situations they are preferred. All other things being equal, I prefer to form LLCs for clients. The “S” in S Corp comes from the election to be treated as an “S” corporation with the IRS and Pennsylvania Department of Revenue when the entity is first formed, which is not the same as simply filing the corporation with the Pennsylvania Department of State. I recommend an accountant obtain the EIN number and make the “S” federal and State tax elections. Both LLCs and S Corps only impose income taxation once – at the personal level (called “pass-through entities”) and they operate in a similar, although not identical way, for most other federal and state taxation issues.
Be aware that almost all banks and often major trade creditors will require personal guarantees – those obligations will not be avoided by an LLC or S Corp. There can also be tax advantages to operating as an LLC or S Corp, which an accountant can discuss. There are certain circumstances where someone can “pierce the corporate veil” and impose personal liability, such as when an employees wages are not paid, but the discussion of those exceptions is complex and fact-specific.