Introduction
I previously wrote about the basics of how to start a business. Limited Liability Company (LLCs) are very popular for businesses, especially smaller ones. LLCs are a hybrid between partnerships and corporations in that the owners (called "members") are more like partners (versus shareholders) but still have the liability protections of larger corporations. Previously, business owners who entered to partnerships did not have the same liability protections.
Basics of LLCs
LLCs are also popular because business owners can customize them almost anyway they please. Although the default relationship between LLC members is a partnership, a skillfully crated operating agreement (the document that governs the LLC) can create a corporate like structure of "units" similar to shares in a corporation. Membership units can have different rights and preferred statuses associated with them similar to shares.
Another advantage to an LLC is choosing profit-sharing models. As a default, LLCs are pass-through entities that are not recognized by the IRS. This means that members report their income on their personal income taxes. However, LLCs can choose to be taxed as a corporation, specifically an S-Corp. This is why business owners don't actually have to choose between an S-corp and an LLC because the LLC can be both. Many people incorrectly believe that an S-Corp is a type of corporation. In reality, it is actually just a tax designation can be used by both corporations and LLCs. LLCs typically want an S-corp status if they are single member LLCs or LLCs with employees. Otherwise, LLC members simply make their income by drawing on the profits of the company.
S-Corps
However, there are requirements and considerations for an LLC that wants to elect an S-corp status. An S-corp must:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Although LLCs are very flexible and a great way to organize your business, their flexibility also means they can be complicated to design, especially when multiple members are involved. Having a clear operating agreement is not only important for running a company, but also keeping the harmony between members. Many disputes arise when one member wants to withdraw from the LLC and without a carefully drafting LLC operating agreement, the LLC may be headed towards litigation. An experienced business law attorney can draft an operating agreement to customize your LLC. Call our office at (630) 517-5529 to schedule a 15-minute complimentary consultation to discuss your business needs with the attorney.
Sources:
https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations