By: Transactional Department
There are substantial liability protections and other benefits to operating the business through a separate entity, rather than as a sole proprietor or general partnership. Two of the most popular entities for small businesses are limited liability companies (“LLC”) and subchapter S corporations (“S-Corp”). Either entity can provide liability protections for the owners. I often get the question “which is the better choice?” The answer is, of course, “It depends on the situation”. Each entity form has certain advantages and disadvantages. So what are some points that you should consider when choosing between an LLC and an S-Corp in Pennsylvania or New Jersey?
1. Cost and ease of formation. Generally speaking LLCs require less formality and are less expensive to form. In Pennsylvania, the formation of an S-Corp requires publication of notice in two newspapers. However, in PA, the formation of an LLC does not require publication of notice in newspapers; this can save some upfront money. In addition, S-Corps are required to follow corporate formalities and should have a corporate book and seal. LLCs are required to maintain records, but generally are not required to have a formal company book. Having a corporate book prepared can cost a few hundred dollars.
2. Ease of ongoing administration and record keeping. S-Corps are more formal. The shareholders and officers are required to maintain corporate minutes and documents. While this procedure isn’t difficult, many people fail to follow the necessary procedures and maintain required records. Failure to follow the formal record keeping requirements and document corporate activities through minutes and resolutions can invalidate the liability protections for offices and shareholders. Structured record keeping and following corporate formalities is very important when dealing with an S-Corp. LLCs have far less formal requirements and the owners can operate the business in a more relaxed manner. The funds of the LLC still need to be kept separate from personal funds and record keeping is still important; but the owners of an LLC have more flexibility to undertake their own style of recordkeeping and record management. Following proper corporate formalities and record keeping is the biggest pit fall area for S-Corp owners, and is more frequently being used to do what is called “piercing the corporate veil”; which is an action that leads to creditors being able to access the personal assets of shareholders.
3. Employment Tax issues. One of the most important and often overlooked considerations is the payment of employment tax on earnings. S-Corp owners have the option of paying lower wages and taking more in distributions to shareholders. Distributions to shareholders are not subject to employment withholdings and employment taxes. Members that are active in running an LLC must address employment withholdings and pay employment tax on their earnings. This difference can save thousands of dollars in employment taxes. This can be one of the largest benefits of using an S-Corp.
4. Flexibility of Structuring Agreements, Financial Returns and Obligations of Owners. S-Corps do not allow flexibility and must adhere to a set structure with shareholders, directors and officers. The voting of the shareholders generally cannot be weighted differently from their investment amounts. Minority shareholders can often be placed in a difficult position, which can make it harder to bring in new shareholders to an established but cash strapped business.
An LLC is highly customizable and can be made to fit a variety of circumstances. The members of an LLC can receive different distribution amounts, have voting powers that are weighted or limited to specific areas, and the relationship between the members can be set up in any way that suits the members. For instance; in an LLC, you can have a member that only owns 25% of the business, but holds 50% of the decision making power over certain management issues. The ability to offer “weighted” voting shares can provide security and peace of mind to potential investors that would otherwise not be willing to infusing cash into a struggling but established and equity rich business. This is just one example of a variety of creative solutions that an LLC can provide.