There are a lot of misconceptions about the difference between LLCs and S-Corporations. We almost never form statutory corporations. However, we routinely create LLCs that are taxed as S-corporations. This article will summarize why we believe that there are very few situations in which a corporation should be formed if it will be taxed under subchapter S, and why every small business corporation should consider converting to an LLC.
1. How a business is taxed and how it is organized under state law are different issues.
There is no such thing as an S-corporation or a C-corporation under the North Carolina Business Corporation Act. There are only corporations. Once you form a corporation, it is taxed under subchapter C unless you elect to be taxed under subchapter S. These are tax issues. But when it comes to non-tax matters, a corporation is a corporation.
2. An LLC can be taxed the same way as a corporation.
Many people think that a multi-member LLC must be taxed as a partnership and that a sole member LLC is disregarded for tax purposes. Those are the default tax classifications. But an LLC with one member can be taxed as if it were a sole proprietorship, a C-corporation or an S-Corporation. An LLC with more than one member can be taxed as a partnership, a C-corporation or an S-Corporation. How a business entity should be taxed is a complicated issue that should be based on specific facts. But it has very little to do with the legal structure. If your CPA told you that your business needs to be an S-corporation, he or she meant that you need to be taxed as an S-corporation.
3. LLCs require fewer formalities than corporations.
Corporations have several required statutory formalities. A large percentage of the corporations that we have represented have a corporate notebook that has a set of bylaws, stock certificates, articles of incorporation, and nothing else. Sometimes those documents haven’t even been signed. It is not uncommon for a very successful family owned business to have never had an annual meeting. Some don’t have any corporate documents, and the only way we can tell who owns the business is from the tax returns.
LLCs require less maintenance. The North Carolina Limited Liability Act specifically says that the purpose of the Act is to “provide a flexible framework under which one or more persons may organize and manage one or more businesses as they determine to be appropriate with minimum prescribed formalities or constraints.”
One way to fix this problem is to simply do what your organizational documents say you are supposed to do. Another is to operate under a form that doesn't require you to do things that you know you are not going to do.
4. Because LLCs have fewer requirements, they may better protect your personal assets from the company’s creditors.
One of the reasons for forming a business entity is to protect your personal liabilities from the potential creditors of the business. Neither corporate shareholders nor members of an LLC are liable for the obligations of the business solely by reason of being an owner. However, that is not an absolute rule. “Piercing the corporate veil” is a judicial remedy that is used in extraordinary circumstances to allow the creditors of a business entity to go after the owners’ personal assets. The concept of “piercing the corporate veil” applies to LLCs as well as corporations.
There are several reasons that can lead to veil piercing. Many have nothing to do with how your business is organized. If you use your business to commit fraud or it is grossly under capitalized, you may be personally liable for the business’s debts, regardless of how it is structured. But one factor in determining whether or not to pierce the corporate veil is failure to comply with corporate formalities. A recent North Carolina Court of Appeals held that non-compliance with corporate formalities “is of less relevance in the context of an LLC, which is subject to far fewer formal statutory requirements than is a corporation.”
Our courts will not allow business owners to abuse the business’s existence to the detriment of third parties. But when there are almost no formal requirements, the plaintiff suing your company cannot show that the business has failed to meet them.
5. LLCs can protect your ownership interest in the business from your personal creditors.
The charging order is probably the most important benefit of an LLC. The North Carolina Limited Liability Act says that the entry of a charging order is the exclusive remedy that a judgment creditor of an LLC owner may use to satisfy the judgment from the LLC. A charging order gives a judgment creditor the right to distributions from the LLC. The debtor's membership interest in the LLC cannot be seized and sold to satisfy a creditor’s judgment. This is not the case with shares of a corporation.
One caveat is that the future of charging order protection for a sole member LLC is not certain. The original policy reason for the charging order is to keep other LLC members from being unfairly affected by the seizure of LLC assets, or of the LLC interest itself. That reason does not exist for sole member LLCs. Several courts across the country have ruled that charging order protection is not available to sole member LLCs. Therefore, if asset protection is an important factor, an LLC should have more than one member.
6. In North Carolina, it is easy to change an S-Corporation to an LLC taxed as an S-Corporation.
North Carolina has a procedure for statutory conversion of a corporation to an LLC. If you do not change the tax classification of your business, you can accomplish this without tax implications. This is not the case if you change the tax classification of your business.
These factors, taken together, show that LLCs are more flexible than corporations and can provide all of the same benefits as corporations. An LLC is the best structure for almost any new small business. If you own an S-corporation, particularly one with more than one owner, and asset protection is a concern, you should consider the benefits of converting from a corporation to an LLC.