Ep. 15: The Great Debate: Understanding the Key Differences Between LLCs and S-Corps Part 1
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Is it better to create a limited liability company or establish a corporation? Each has its own pros and cons depending on whether you are an independent contractor, a small business, or a real estate investor. In part 1 of this two-part discussion, Attorney Ted Gudorf explains the key differences between LLCs and S-Corps.
Members make up a limited liability company, or LLC. Any entity or individual can be a member of an LLC, with some notable exceptions being banks or insurance companies. The operating agreement, commonly overlooked, is every LLC’s governing document, listing members and their percentage ownership, as well as capital contributions.
Corporation owners, however, are referred to as “shareholders,” not “members.” For the most part, rigid formalities must be followed in order to enjoy the benefits of the corporation. The bylaws of a corporation are those that provide for shareholders, directors, and officers. In some states, professionals have to use a corporation and not an LLC.
In part 2 of this discussion, Ted will delve into a number of complex issues in designing the limited liability company operating agreement or the S corporation bylaws.
- What is an LLC? (1:20)
- How LLCs are taxed (6:56)
- What is a corporation? (15:55)
- How corporations are taxed (17:28)
- Choosing between an LLC and a corporation (22:00)
- How about a sole proprietorship or general partnership? (29:24)
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This is Episode 15, LLC versus Corporation, which entity is best? Thanks for being with me today, we have got a really interesting and important topic to discuss with you. Is it better for you to create a limited liability company or establish a corporation? What makes the most sense if you are an independent contractor, a small business, a real estate investor, an investor in securities, or some other business. We are going to talk about the pros and cons of each. Before we get into that, I just want to give everyone a shout out. You know, this is a cold March day here in Ohio, we have had snow today of all things. Looks like snow is going to bring us in on St. Patrick’s Day. I hope all of you have a cheerful St. Patrick’s Day and celebrate in grand style.
Well, let us get into our program today, and let us talk about the difference between these two entities. First, let me cover what a limited liability company or an LLC is in general. When you own a limited liability company, the owners are called members. Any entity or individual can be a member of an LLC, with some notable exceptions being banks or insurance companies. Sometimes we even see trust as being members of limited liability companies. It is critical to understand that it takes more than just filing articles of organization with the Ohio Secretary of State to establish a limited liability company. Oftentimes, I will see somebody come into my office, and they say they have an LLC, and then I ask to see their operating agreement, and they have no idea what I am talking about and indicate that they were never told that they had to have one. In order to properly form a limited liability company, it has to have an operating agreement because that is the governing document. That operating agreement has to provide for things like members, it identifies them, as well as their percentage ownership. It identifies perhaps the manager of the limited liability company, in some instances, will have manager managed LLCs rather than member managed LLC, frankly, for the most part, most of my limited liability companies are manager managed, whereas one of the members will typically step forward and be a manager and will have very specific provisions pertaining to the manager. The operating agreement will also address capital contributions. How do we go about adding additional members? How do we hold a meeting, whether it be a regular meeting, an annual meeting, a special meeting? Can we simply pass resolutions by written unanimous consent without a meeting? What type of records are we going to maintain? How do we get out and dissolve the limited liability company? Are the officers of the limited liability company going to be indemnified by the company? How do we amend the operating agreement? And most importantly, are we allowed to transfer our membership interest?
The advantages of limited liability companies are fairly well known. The bottom line is asset protection. That is that the owners will have their other Non LLC assets protected from any LLC liabilities. Oftentimes, that is our primary goal. We want to make sure that our bank account, our brokerage account, any other assets that we own, our house, are protected from the liabilities associated with the business entity, the limited liability company. Just remember though, if you are the one who is at fault, that is, you are the one who is negligent, you are always going to be responsible for that negligence. Sometimes, as people come into my office and want to talk about a limited liability company, they seem to somehow think that they are going to avoid liability for their own negligence, and that simply is not the case under the law of any state. So, if you are the only person operating the business, and you are the only employee, and you are the one who is at fault, your personal assets, if not otherwise protected, are still going to be at risk. That is why at times, we have to discuss with our business owners, making sure that we have both inside and outside liability protection. One of the other advantages of LLCs compared to corporations is that they are very flexible, we can put provisions in the operating agreement and state law will allow us to pretty well go and establish whatever kinds of guidelines we want within the operating agreement. We can provide for officers, but we do not have to; we can provide for annual meetings, but do not have to. We can require there be a manager, but we are not required to, we can require that a percentage, a high percentage of members have to consent to perhaps sell all of the LLC property or to file bankruptcy or to liquidate the assets of the company. Clearly, the LLC allows us a lot of flexibility with respect to distributing any of the profits. Bottom line is there are a lot fewer corporate formalities, and there are some tax benefits that we will talk a little bit about.
Speaking of taxes, one of my favorite things about LLCs, which is not understood much is that an LLC can be taxed really in four different ways. First of all, if you are a single member LLC, it can be a disregarded entity, that is there is no federal income tax return, even required for the LLC. Why is that? Well, federal law allows a single member LLC to be disregarded. It is the simplest tax structure that there is. If we have a single member LLC, perhaps we will simply report that LLC’s activity on a schedule C, that is a part of our 1040 tax return. A disregarded entity is common for an individual who puts their brokerage account within an LLC to protect it, or perhaps you have rental real estate, and you are the sole owner, and you want it to be a disregarded entity. Yeah, that works out quite well. But the LLC does not have to be a disregarded entity. It can be taxed as a partnership and, in fact, in most instances where we are going to own real estate, and have more than one member involved, we are going to elect to treat it as a partnership, where we are going to be required to file federal form 1065 to report the partnership activity.
Now, an LLC can also be taxed as an S corporation. It does require a Federal Form 1120-S. Obviously, it is going to also require a state income tax return, but just remember when we are doing an 1120-S, there is no federal corporate tax due or payable, instead it passes through to the individual shareholder. Now, the S corp, as a general rule, is not recommended for real estate investors. I recently had a farm client decide to form a limited liability company and tax it as an S corp, and we are going to talk about this a little bit, but his primary goal was to save on self employment tax, that 15.3% tax that is required to be paid, we were able to avoid it by establishing a reasonable salary for this farmer and paying the 15.3% on the reasonable salary, but not pay it all the way up to the first 150,000 or whatever the current federal limit is on self employment tax. Now, just remember, the LLC can also be taxed as a C corporation. It is uncommon to do that, but it does occur in some circumstances. Again, it requires Federal Form 1120 to be filed, and again, it is not recommended for real estate. So, we have a lot of tax flexibilities with our limited liability companies, we have four different tax options we get to pick, and by the way, we can change from one to the other as long as we follow the rules pertaining to how to do that.
In most cases, LLCs do not pay income and capital gains tax on their profits directly. Just remember, in most instances, those profits are going to pass through to the members who report them on their individual tax returns. When we are dealing with Ohio law, and limited liability companies, know this, Ohio adopted its first limited liability statute all the way back in 1994. It was not substantially changed until recently, when the Ohio General Assembly adopted the revised Limited Liability Company Act that took effect on February 11 of 2022. Now, this new Act, in fact, is now located within Chapter 1706 of the Ohio Revised Code, and totally replaces chapter 1705. It completely redrafted Ohio statutory law. If you have previously, prior to February 11 of 2022, established an Ohio limited liability company, I highly recommend that you get with somebody to review your operating agreement to make sure that it now references chapter 1706, and that you go through the provisions of the new law and determine whether you do or do not want the provisions of chapter 1706 to apply to your Ohio limited liability company.
One of the things that the new Ohio Act allows us to do is it removes the default provisions requiring member managed or manager managed LLCs to allow for greater flexibility in the management structure of the limited liability company and also for our real estate investors, it established for the very first time in Ohio the ability to create what is called a series LLC. The series LLC is a concept that was initiated in the state of Delaware and a handful of other states. It allows the operating agreement to designate certain assets and liabilities as a part of an individual series where the debts and liabilities are only enforceable against that particular series, and the LLC as a whole is not impacted. So, if you have an example where we have say 10 rental properties, and let us say we have each one rental property in each series, series one, series two, series three, all the way down to series 10, each of those series could have a different EIN number. It could have different members as partners. It could be required to file separate tax returns. It could even have separate bank accounts. The idea is you are only having to file one LLC with the state of Ohio, rather than having to pay the filing fee for 10 LLCs.
What’s the difference? Well in Ohio, right now, we charge $99 for filing each LLC. So, if we are creating 10 of them, we would have to pay $990 just in the initial filing fee, but if we have a series LLC, it is only going to be one filing fee of $99. So, we will see where the series LLC goes. I have created a couple of them, kind of unique circumstances, but we will see where it goes and how widespread they are going to be used. Clearly, it is going to be used for those involved in real estate.
Some of the other parts of the new law allow greater flexibility by permitting LLCs to retain their current operating agreements. That is a good thing. One of the things though that is really new is something called a statement of authority, and that statement of authority allows an LLC to file a statement with Ohio Secretary of State setting forth a particular person’s authority to enter into transactions on behalf of the LLC. The statement of authority may also be submitted for all persons holding a specific role with the LLC, and therefore third parties can rely upon that statement of authority as conclusive evidence that the person executing a transaction has the authority to do so, that should provide us with greater clarity with respect to an individual’s authority to enter into a transaction on behalf of the LLC.
Well, let us talk a little bit about a corporation. Most of us are familiar with a corporation. Just remember, in general, owners are not called members, but instead are called shareholders. Corporations, for the most part, have rather rigid corporate formalities that must be followed in order to get the benefits of the corporation. Now a corporation is governed by bylaws. The bylaws of a corporation are those that provide for, again, who are the shareholders? Who are the directors? Who are the officers? How do we fill vacancies? Whether it be in shareholders, directors or officers? What about meetings, corporate records? How do we issue stock certificates? Are the officers or directors going to be indemnified? How do we amend the bylaws, bottom line, all of that is incorporated and included within the bylaws. In some states, professionals have to use a corporation and cannot use an LLC. Here in Ohio, lawyers are allowed to use either a professional corporation or a LLC, but in some instances, we have to have a corporation. Generally, that is true within the medical field. Corporations are oftentimes used for operating businesses. Just remember there are two ways to tax a corporation. Just like the LLC, corporations can be taxed as an S corp. It is an election for the income taxation of the corporation to flow through to the shareholders directly. An S Corp is a choice for tax treatment of either an LLC, or a corporation.
Now, a corporation can also be taxed as I previously indicated as a C corp. That is a standard classification of a corporation. By the way, by default, unless you elect otherwise, an LLC with more than one member is going to be taxed as a partnership. Whereas a corporation by default, will be taxed as a C corp unless you elect otherwise. Now, in order to elect to treat your LLC, or your corporation as an S corp, you have to file Form 2553 with the IRS. That form is simply called Election by a Small Business Corporation. If you again do not file that form, and elect to be treated as a an S corp, by default, you are going to be treated as a partnership if you are an LLC; you are going to be treated as a C corp if you are a corporation. Now, just remember, an S corp has some restrictions. Now, if you are a small business owner, these restrictions generally do not apply, and that is why most small businesses choose to be an S corp, you must have 100 or fewer shareholders, two – the shareholders must be US citizens, or permanent residents. Corporations, partnerships, or business trust cannot be shareholders, and you can only have one class of stock if you are an S corp. Now, you are allowed to have voting and nonvoting shares, but only one class of stock in order to be an S corp. As it pertains to the income tax of S corps, just know that the taxable income, the credits, the deductions and the losses pass through directly to the shareholders, that is there is no corporate tax. There is an opportunity to have dividends versus a salary and save some taxes. Once again, you have to pay yourself a reasonable salary. Having said that, any distribution above and beyond that reasonable salary up to the statutory limit does not have to pay the 15.3% Social Security tax. One of the main reasons why a lot of small business owners have been encouraged to elect S corp treatment on behalf of their corporation is so that they can pay themselves a reasonable salary, say $50,000 and have their other income treated as a distribution, knowing full well that those distributions will not be subject to a 15.3% self employment tax. Now, despite the IRS raising some alarms about the reasonable compensation issue of S corps, it is still the law today. To give you an example, if you are making $130,000 worth of net profits on your business per year, and you pay yourself a reasonable salary of $50,000; you do not have to pay the 15.3% tax on the $80,000 that is a distribution, that in and of itself can result in over a $10,000 per year income tax savings. So, it is one of the key things to look for. Again, it is one of the main reasons why small business owners like to be taxed as an S corp. It is simply important, though, that you do an analysis before you make the election. Because what is the downside? Well, the downside is you have to pay yourself a salary, you have to do payroll, and anybody who has ever done payroll withholding know that it can be a real difficult painful exercise to file those payroll returns or to hire a firm to do your payroll for you.
Now, if we are a C corp, just know that C corps can be good tools for complex businesses or businesses with foreign shareholders. The qualified small business stock company is good for perhaps a startup company that is expected to be sold because it can exempt up to $10 million of federal capital gains taxes per year per taxpayer. That is a big deal if it is applicable to your situation, not applicable oftentimes in my practice, but it is something that does arise on occasion. What are the advantages again of a C corp? Well, first of all, the shareholders have liability protection, the most the shareholders can lose is their investment in the corporation. Now just remember, if you are an officer, you may be held liable by virtue of being an officer. One of the other main reasons why people create C corporations is that it gives them access to capital. Corporations can raise funds by selling their shares publicly. There is no limit on the number of shareholders that a C corp can have and getting out of a C corp is very easy. It is easy to buy and sell. What are some of the disadvantages of having a C corp? I think the couple of things that I would point out. First of all, if you have got a C corp, you really have to follow the corporate formalities, you have to follow those bylaws very carefully. You have to maintain the board of directors, you have to hold regular meetings, you have to keep board minutes, you have to prepare annual reports. So, it certainly requires more work on your part. It is more difficult to establish. The bylaws have to be carefully drafted by an attorney who regularly drafts bylaws, they need to counsel and advise you as to all of the different issues. How you are going to appoint your board of directors, what the shareholder agreement is going to provide for with respect to buyouts. You have to issue stock certificates, and just remember, the primary disadvantage of a C corp is the double taxation. While that can sometimes be worked around, it is certainly an issue that you have to think about and talk about. C corp is the traditional corporation that pays taxes at flat rates and, of course, President Biden has indicated his desire to raise the tax rate for C corps all the way up to 28%. We know we finally got implemented an AMT for C corps, so we are going to pay particular interest with what Congress is going to do over the next few years as to whether they are or are not going to raise the corporate tax. Obviously, we do not like to pay tax on our money twice.
So, which one is better for you? Well, let us talk a little bit about if you are an independent contractor, you are running a small business, maybe you are wanting to manage your personal investments, or you are involved in real estate investing, bottom line is these are ideal circumstances for you to have an LLC or Limited Liability Company. Why? Because you have management flexibility. The law allows for informality, you can establish disregarded entities. In my view, everybody who has a personal investment account, if you have investment assets, it should not be owned in your individual capacity, it should not be owned by your revocable trust. In my view, structuring and holding your investment assets, segregating them from your personal liabilities are really important. I think every brokerage account should be owned by a manager managed limited liability company to provide you with a degree of protection, and then if you want more protection than what the charging order protection is for limited liability company, you have that limited liability company owned by an Ohio Legacy Trust, even better.
Real Estate, ideally situated residential real estate will provide you with some asset protection. It is essential for commercial properties, whether it be office retail or industrial. It is essential for ranching or farming operations. Why? Once again, we are going to get asset protection, we are going to isolate the liabilities, we are going to provide flexibility in management and in making distributions. LLCs in my view for real estate beat corporations every single day of the week. It can be very easy to get into but very difficult to get out of an S corp, a C Corp, or an LLC taxed as an S or C Corp. Having said that, LLC is taxed as partnerships or disregarded entities are far better, and are far easier to get out of if we have them. Just remember that real estate and corporations do not play well together. Owning real property in a corporation is generally a bad idea. Problems arise when you are trying to move real property in and out of the corporation. You transfer appreciated property into a corporation may cause a recognition of capital gain. If the corporation assumes debt on the property, capital gains may be triggered. Transferring property out of a corporation can also be a taxable event. Capital gains will be higher when you are selling, it is 21% on the corporation level, and then of course, the shareholders have to pay tax on the dividends, and there is no adjusted cost basis at death on the assets that are owned by the corporation. Just remember that all of your entities do require some maintenance. It requires consulting with a good CPA, a good tax advisor, as well as making sure that you keep your estate planning attorney up to abreast with your business.
Obviously, you always have another option. Simply do not register a business entity, you can create a sole proprietorship where one person conducts business without even forming an entity. Or you can create a general partnership when two or more persons conduct business for a profit without an entity. But just remember, there is a huge downside to not having a business entity. The downside is for both the sole proprietorship and the general partnership, there is no liability protection, you have little credibility out there in the business world, the state of Ohio default rules are going to apply whatever those rules are, you cannot opt out of them, and for partnerships, getting out of partnerships, a general partnership can be tricky. Partnership taxation is complicated, and remember, partners have fiduciary duties one to another, and most importantly, you have joint and personal liability. So, joint liability and personal liability. I remember my law school professor telling me, there is really rarely ever a good opportunity to have a general partnership. It just rarely, never make sense, and if you are one who is engaged in one, understand that you are going to be held responsible for the liabilities of your partner. Think about that. Why would you want to do that when there is other opportunities by creating a business entity that will allow you to steer clear of those liabilities? Well, I hope you enjoyed this conversation.
There is a significant difference between a limited liability and a corporation. Today I wanted to cover the basics. This is part one, stay tuned to part two, where we will delve into some more complex issues with respect to how we design the limited liability company operating agreement or the S corporation bylaws. Have a great day. Thanks for being with me today. Happy St. Patrick’s Day.