LLC Versus S Corporation Overview

For more than a decade, our Chicago business attorneys have advised business and corporate clients on the distinct differences between an Illinois limited liability company and Illinois corporations electing to be taxed as S corporations from both tax and business standpoints.  Deciding between starting an LLC or incorporating an S corporation to conduct a business is generally decided on whether a flow-through tax treatment is desired. In general, flow-through tax treatment means that the business entity itself is not subject to tax. Rather, the owners of the business will report their shares of the business’ income, gains, losses, deductions, and credits on their own tax returns.

Although an LLC and an S corporation may provide the desired flow-through tax treatment, an LLC is generally taxed as a partnership under Subchapter K, while an S corporation is taxed under Subchapter S. These tax elections are not the same.

It should be also understood that an Illinois limited liability company may elect to be taxed under Subchapter S.

S Corporation Business Owners

Probably the most significant difference between a limited liability company and an S corporation is the restriction on who can be a shareholder of an S corporation. Only individuals other than nonresident aliens, grantor trusts, qualified Subchapter S trusts, electing small business trusts, certain estates, qualified retirement plans, and charitable organizations can be shareholders of an S corporation. Thus, an S corporation cannot have as a shareholder a nonresident alien, a corporation, a partnership, a limited liability company, or a non-qualifying trust. For LLCs, no such restriction exists. Any individual or entity can be a member of an LLC.

Business Income and Business Losses

Another difference between an LLC versus S corp is the allocation of the business’ income and losses among the owners. An LLC, which is most often taxed as a partnership, is subject to the allocation rules of Internal Revenue Code §704(b). That section generally allows any allocation of income and loss among the members as long as the allocation has substantial economic effect. For example, members who provide capital to the business can be provided a preferential return, similar to interest. Allocations among members may be determined at the end of the year based on the LLC’s operating results and may also vary from year to year. Likewise, distributions to the members may be flexible. For example, members providing capital may receive a return of their capital before any distributions are made to members who do not.

Although an Illinois limited liability company and an S corporation may provide the desired flow-through tax treatment, an LLC is generally taxed as a partnership under Subchapter K, while an S corporation is taxed under Subchapter S. These tax elections are not the same. It should be noted, however, that an LLC may elect to be taxed under Subchapter S.

S Corporation One Class of Stock Rule

An S corporation can have only one class of stock, although it may have both voting and nonvoting common stock. Thus, each share must be treated the same as every other share with respect to allocations of income and losses and distributions. Therefore, an S corporation cannot provide a preferential allocation to any shareholder. Similarly, distributions cannot be made to some shareholders and not to others.

Liquidation of Business

The tax treatment of the owners upon the liquidation of an S corporation and a limited liability company is different. Under partnership rules, liquidations can generally be accomplished tax free. Tax liability may arise when the amount of cash distributed to the member exceeds the member’s basis for his or her interest or when unrealized receivables or inventory items (hot assets) are distributed.

In contrast, the liquidation of an S corporation is treated the same as the liquidation of a C corporation: it is a taxable transaction. Any distribution of an asset in liquidation of the S corporation is treated as a sale of that asset for its fair market value. Any gain is allocated among the shareholders and must be included on their individual tax returns even though the asset was not sold to a third party.

Non-Tax Business Issues

Although tax issues will generally be the most critical in deciding whether to organize a business as a limited liability company or an S corporation, business operation concerns should also be addressed.

An LLC and an S corporation should be treated similarly; the owners should not be liable for any debts or obligations of the entity. In the case of an S corporation, which is organized like any other corporation under state law, this is clearly the case. A significant body of case law has developed over the years addressing this issue. Except in unusual circumstances, when attempts may be made to pierce the corporate veil, most business lawyers feel quite confident that organizing a business as a corporation (whether taxable as a C corporation or an S corporation) will protect the shareholders from liability as long as the corporate formalities are observed.  For LLCs, however, the law may not be as clear in particular circumstances.

Contact Our Law Firm– 312-789-5676

Our Chicago business attorneys provide counsel and advice to those entrepreneurs, professionals and businesses who seeking to launch a new business. We assist clients in everything from the business entity selection during formation to the sale of a business. We offer reasonable hourly fee arrangements, flat-fee or fixed-fee services, hybrid fee services, and contingent fee services for the majority of business transactional matters.