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The last portion of this article discussed how individuals historically incorporated their businesses in the hopes of avoiding personal liability, but then often became dissatisfied with the so-called “double taxation” thereby resulting. This, among other motivations, brought the S-Corporation and limited liability company (LLC) into being.
The S-Corp versus the LLC
Society clearly benefits from encouraging people to start businesses - and take some commercial risks without an attendant risk of personal ruin. Yet otherwise well-intentioned and well-motivated people were either quitting businesses or exposing themselves to personal liability - in both instances due to their aversion to the so-called “double layer of taxation” engendered by the C-Corp. Additionally, the “double” taxation of the C-Corp was creating a disincentive for new people to go into business - particularly those who were risk-averse. There had to be a better way.
That better way, at the time, was the S-Corp, which came into existence a number of years ago principally for the above types of reasons and rationales. It was named after a “Subchapter-S” in the Internal Revenue Code, and was regularly recognized by the IRS and state tax authorities alike.
Akin to the C-Corp in most other respects, the S-Corp only mandated a single layer of taxation, as opposed to the C-Corp’s double layer. But there were also a few catches.
One had to make formal written “elections” to qualify as an S-Corp. If one didn’t do so in time by a strict deadline, one would lose S-Corp status and be “doubly” taxed like a C-Corp instead. There were other restrictions, such as a limit on the number of shareholders, a limit on foreign ownership, and a limit on corporate parent-subsidiary ownership. (Some of these restrictions have been loosened - and in some cases eliminated - in recent years; so one should not rule out the S-Corp without first updating its tax code requirements with one’s lawyer and accountant). The historical restrictions of the S-Corp put business owners in a “Catch-22” situation - they clearly wanted a single layer of taxation, but in the context of an entity that wasn’t so restricted. The newer solution: the LLC.
The LLC is like the S-Corp but without most of the attendant historical restrictions. Yes, there were a certain number of restrictions on the LLC, too, when it first appeared on the scene - most of which were subsequently lifted by either the IRS or state legislatures, or both. Again, S-Corp restrictions have also been lifted in recent years, making the S-Corp and LLC look more similar to each other as time goes on.
But even as of this writing, the LLC is usually considered the most advantageous entity from a tax perspective of all 3 most commonly available forms, for the small business owner to create. The LLC is also considered the most flexible of all 3 entities. What does “flexible” mean? Well, it is considered easier to adapt the LLC to later-occurring additional equity-holders in one’s business, for example - and the word “easier” in this context translates to “less legal fees”. The LLC is in most cases an entity which is easier to manage and administrate.
There are some disadvantages to the LLC, too. The LLC can take more time to finalize, and in some cases can be more expensive to form and/or file with the government - as compared to an S-Corp. Some states may (still) prohibit 1-person LLC’s as of this writing, although that trend is abating, thankfully. Some states still have an underdeveloped body of judicial case law on the LLC, since the entity is still quite new in many states - so the treatment of the LLC under the law may be less certain than the treatment of a corporation. We in New York have an odd restriction, too, as a result of the powerful newspaper lobby galvanized during the legislation’s enactment - which restriction may be present in another state or two as well in analogous form. If one elects to form a New York LLC, one must publish its existence in periodicals for a number of weeks, before being accorded the legal privilege of initiating a litigation - as a plaintiff - in the LLC’s name in the New York courts. Publication of an LLC’s naissance in Manhattan is expensive - the publication in periodicals of the creation of a proposed Manhattan LLC can range between $1,500 and $3,000 (the figures can vary and are smaller in other parts of New York State apart from Manhattan).
Even so, the LLC is considered the trend-setting entity of those “in the know”. And part from hype, assuming that one can afford to form it, and assuming that one can live with whatever restrictions apply to the LLC in one’s jurisdiction, it may in fact be the entity of choice, and an improvement over the older S-Corp and C-Corp structures.
An LLC is technically not considered a “corporation” - it is an unincorporated entity, but one that (like the S-Corp and C-Corp), if properly formed and maintained, should provide its members with insulation against personal liability.
If one doesn’t incorporate (or form an LLC), the business will likely be what is known as either a sole proprietorship (if a 1-person company), or a general partnership (if comprised of 2 or more persons). This could result in unlimited personal liability for the entity’s owner or owners. Again, that means that an owner’s personal assets can be at risk to satisfy the obligations and debts of the business. Personal liability is not a risk worth taking. In addition, using a corporate entity or LLC could add a good deal of “cachet” or credibility to one’s business endeavors, in the eyes of other persons and companies with whom the business has contact.
My law practice includes the fields of entertainment and publishing. If you have any questions about copyright law or any other legal issues which affect your career, and require representation, please contact me:
John J. Tormey III, PLLC
217 East 86th Street, PMB 221
New York, NY 10028
(212) 410-4142 (phone)
(212) 410-2380 (fax)
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