Choice of entity considerations: LLC or Corporation?
As a practical matter, the protection for LLCs might be stronger than that for corporations. While courts purport to apply the same corporate veil standards to both corporations and LLCs, the grounds are often relaxed for LLCs, both for inadequate capitalization and for failure to observe corporate formalities. In fact, several states have decreed by statute that the failure of an LLC to observe corporate formalities may not serve as the sole ground for imposing personal liability on any LLC member.
For an LLC electing to be an S corp, a business owner may need to modify this agreement before electing S corporation status, so as not to violate the single-class-of-stock requirement (depending on the terms of the existing operating agreement).
An LLC’s ability to easily convert to another entity may work well for a startup with plans of someday undertaking an initial public offering. However, encouraging investment with an LLC as the chosen entity may be a problem for startups requiring additional funding. Tax-exempt organizations, such as qualified pension plans and individual retirement accounts, provide a significant capital pool for private-equity funds and venture capitalists, which in turn operate as a major source of funding for startups seeking capital. Private-equity funds consisting of these organizations, which are generally exempt from income tax on passive investment, are subject under Sec. 511 to tax on unrelated business taxable income (UBTI) when investing in an LLC.
An LLC can also make an election to be taxed as a partnership, an S corporation, or a C corporation, without actually converting to one of these entities. Many states allow for an entity to do a “conversion” to another entity rather than shut down one and create the new one. For example, Michigan allows for a LLC “conversion” to a corporation using a specific form.
Depending on the state’s legal treatment of how this is done, the IRS may allow for the entity to continue using the same EIN even though the underlying entity is a new legal entity.
For more information of choice on entity consideration, contact a ShindelRock advisor.