LLCs v. Incs. :: How to Decide and How to Convert

On April 13, 2008 by

The Limited Liability Company is finally a mature entity in the United States. While historically the entity has been here and there since the 70s, it wasn’t until 1996 that every state in the U.S. had accommodated the L.L.C.

While a toddler, many were skeptical of the LLC entity. Lawyers and accountants were unfamiliar with the new entity, and were hesitant to give advice when the entity had not been tested in law or in the practical world.

More than one decade after that mid-nineties milestone, however, the L.L.C. is alive and well, and has proven itself to be the entity of choice in America. Accountants, lawyers and the general public are now comfortable with the entity, and its treatment under tax regulations and liability jurisprudence has been tested and made clear.

Despite its overwhelming popularity, however, many are still confused about the differences between the LLC and the Inc. These differences, however, are crucial to your business. The incorrect choice in entity type may defeat the purposes of the entity entirely.

In the Construction Industry where liability exposure and risk are high, it’s important to understand your choices in entity types. This article discusses the differences between the LLC and the Inc., their pros and cons, and the ease of converting from one to the other.

LLC v. Inc.
Generally speaking, if you are a small to mid-sized company, you are likely to be better off as a Limited Liability Company (LLC) than a Corporation (Inc.).

A corporation is required by statute to have stockholders, officers and a board of directors. While the Inc. may have only one stock holder and one director, it must have two individual officers. This means a corporation with one stockholder must pull in a second and willing individual to trust as an officer.

Corporations are also required to keep certain corporate records, take votes on decisions, record their meetings through minutes and have annual meetings with its stockholders (even if there is only one).

While large organizations benefit from the structure of a corporation and require it to thrive, small companies fall fate to the structure.

In reality, a small business will have a difficult time meeting the formalities of a corporation, and as a consequence the corporation’s liability shield may potentially be pierced in the event of a dispute.

Prior to the introduction of the LLC, there was a void between sole proprietorships or partnerships and full-blown corporations. Small businesses were simply stuck with the corporation as an entity type, because the only alternatives were sole proprietorships and partnerships (both without liability protection).

A Limited Liability Company fills this gap completely. It does not have the same formalities of an Inc., but it offers its members the benefits of liability protection. The entity is seen by many as a blend between the partnership and the corporation, and from the perspective of a small business, an entity taking the best qualities of each.

The LLC offers the flexibility and informality of a partnership, but maintains the liability protection of the corporation. In the spirit of its accommodating nature, the LLC allows its members to elect how it will be taxed: either as a corporation or a partnership. It’s the absolute best of both worlds for a small business owner.

Taxing a LLC
After the LLC entity was introduced in the United States, the Internal Revenue Service did not create a special taxation classification for it. To the contrary, the Treasury Regulations Section 301.7701-3 was pieced together, offering guidance to the LLC organizers on the tax classification for their new company.

Generally speaking, the manner of classifying a LLC is entirely up to the members of the company, and the IRS is very flexible in how it will tax the LLC entity.

A single member LLC generally has the following choices:

  1. File Form 8832 to be taxed as a corporation f8832.pdf
  2. If qualified, file Form 2553 (f2553.pdf), Election by a Small Business Corporation (Under Section 1362 of the Internal Revenue Code) to be taxed as an S Corporation
  3. Be taxed (by default) as a disregarded entity (individual single member are taxed as sole proprietorships, business entity single member taxed as a division of the corp.)

Multi-Member LLCs have the following choices:

  1. File form 8832 to be taxed as a corporation f8832.pdf
  2. If qualified, file Form 2553 to be taxed as an S-Corporation f2553.pdf
  3. Be taxed (by default) as a partnership

In Louisiana and Washington, a husband and wife who are owners of an LLC and share in the profits of the LLC can file as a single member instead of a multi-member LLC. However, they may also file as a multi-member LLC. This is generally true for other community property states as well, including Arizona, California, Idaho, New Mexico, Nevada, Texas and Wisconsin).

Converting Your Business from an Inc. to a LLC
Converting from an Inc. to an LLC is simply and fairly inexpensive. It requires that you file a certificate of conversion with the Secretary of State’s office, along with the LLC’s Articles of Organization and its Initial Report.

You must also notify the IRS that the company has converted to the LLC entity. This is important, as you’ll make your tax classification election at this time. As above-mentioned, your options for tax treatment are varied, and it will depend greatly on the practical needs of your business. You should review these options with your attorney and CPA.

Your Tax ID Number should stay the same, and if you choose, you can even have your tax classification remain unchanged.

Whether or not it is the correct entity type for your company, if your organization formed between 5 and 10 years ago, it’s likely that you formed as a Corporation.

The LLC entity is a safe alternative, and it may be the right entity type for your company.

Related Articles:
The Limits of Liability: Piercing the Corporate Veil

On Apr 13, 2008