“Are you saying that I put an abnormal brain into a seven and a half foot long, fifty-four inch wide GORILLA? Is that what you’re telling me?” – Dr. Frederick Frankenstein, Young Frankenstein

In our prior blog post we observed that for a majority of start-up situations we recommend the founding investors consider either a limited liability company (LLC) or an S Corp in order to achieve tax efficiency. But what are the respective benefits of an LLC and an S corporation and when is it right to prefer the one to the other?

This turns out to be a deep question. In fact, it might require a semester or two of law school in order for you to appreciate the answer fully. But let me offer an abbreviated answer. It depends. Each form of business entity suits particular endeavors, and doesn’t suit other enterprises.

To give you a better understanding of why this is so, let me start with a simple explanation of the difference between an S Corp and an LLC.

A S-Corp is not, in and of itself, a separate type of corporate entity. An S-Corp is a regular corporation, formed under the laws of whatever state you choose to incorporate in, for which an “S” election is made with the Internal Revenue Service and the state department that manages corporate taxation in the state and locality where your corporation is doing business. The S-Corp is still a normal corporation and subject to the general rules and laws governing corporate entities — it is formed by Articles of Incorporation, governed by bylaws, and subject to all the statutes and case law that pertain to a normal corporation. As such, an S-Corp will have the usual slate of officers, including a president, treasurer, and secretary, as well as a board of directors.

Making an S-Corp election has the effect of enabling the corporation to be treated as a flow-through entity for purposes of corporate taxation. We will more fully discuss the significance of this election in a subsequent blog post. But for now, a simple explanation will suffice. The S-Corp election is intended to solve the problem of double taxation at the corporate and shareholder level; however it is an imperfect solution inasmuch as the election is not available in certain cases. In order to qualify for the election, the following conditions must be satisfied:

• The corporation must only have a single class of stock;
• There must be no more than 100 shareholders; and
• None of the shareholders can be nonresident aliens and typically the shareholders must be people, as opposed to entities.

So if any of those conditions are not satisfied your decision is easy to make. Your best option to avoid double-taxation will be to form your new entity as an LLC.

There is one other significant reason why an LLC may present a better option for your start up — it is a fundamentally different type of business entity. Unlike a traditional corporation, a limited liability company is a creature of both statute and contract. It is subject to a different set of provisions in a state’s corporate code and more importantly an LLC will also be governed by an Operating Agreement (OA), which is a contract put in place by the founding investors. The OA is what provides you with significant flexibility in establishing rules for the governance of your new entity, creating multiple classes of shares and/or devising a membership structure suited to your situation. At the same time, an LLC imposes no restriction on the number of members or who may be a member.

So the choosing between an S-Corp and an LLC often boils down to this – if you are setting up a new company that is relatively simple and straightforward, doesn’t require multiple classes of stock, nor do you anticipate bringing in a large number of shareholders, then an S-Corp may be well suited to your purposes. If however, you want to be more creative in terms of establishing a corporate structure, with a set of rules for governance that are tailored to your specific needs, as well as crafting unique terms for financial interests and distributions, then an LLC will likely be a better approach. An LLC with its Operating Agreement is essentially a “free form” approach, with rights and privileges for investors however you want them to be, subject only to the limits of your imagination and the drafting ability of your counsel.

In our next blog post we’ll look more closely at the differences in treatment of an LLC and S-Corp under applicable laws.