Volume 3 Issue 5

Sept/Oct 1999

© by Newland & Associates

In the previous issue, I discussed the development of the concept of Limited Liability Companies or LLCs, the new business kid on the block. Since this new business concept has not yet become a household word, my law practice still receives many calls from individuals who state "I want to form a corporation." In most cases, what they really mean is "I want to have limited liability from some business risks."

To begin the process of determining the best entity for a particular situation, the first step is to understand how they differ. The differences between an LLC and an S (flow through) corporation are shades of gray.

For example, usually, neither entity pays tax at the entity level, but they are subject to different sets of tax rules. So, how does one make the decision between incorporating or organizing an LLC?

Perhaps the best way to think of the difference between S and LLC is to say that LLCs are, in reality, partnerships with one very important attribute — Lord Wadbottom's (remember him from last time?) cherished limited liability. While S corporations also have limited liability, they originated on the opposite side of the continental business divide.

S corporations are a creature of Federal tax law. When you form a corporation, most states, including Virginia, do not even need to know whether an IRS election is filed in order to have S corporate tax attributes (gain or loss) taxed at the shareholder level.

Because S corporations started as corporate animals, much of the baggage of corporate being carried over. For example, S corporations usually have shareholders, directors, minutes for shareholder and director meetings, and stock certificates. As in corporate law, shareholders' basis in their stock in the S corporation does not include any basis in loans to (or for) the entity.

LLCs, by contrast, come from partnership origins. When an LLC is formed, Articles of Organization (quite similar to articles of incorporation) are filed, and, in most cases, an Operating Agreement, which is nothing more (or less) than a partnership agreement, is prepared. Limited liability and statewide name registration are about the only things "corporate" with LLCs.

Is an LLC Operating Agreement needed for a one-person LLC, since sole proprietorships do not have anything akin to an agreement with the sole owner? In order for the one-person LLC to have limited liability, the separateness in identity between the LLC and its owner must be established. Thus, LLCs need an Operating Agreement, minute book, certificates of membership, entity bank account, and similar documentation.

Many of the same considerations also apply to an S corporation. Is there a minute book, entity bank account, stock certificates, Federal Employer Identification Number, etc.?

In the next issue, we will consider the advantages of LLCs over S corporations as the subject relates to flexibilities in allocating profits, losses, deductions, and similar boring items.

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