Given the income tax advantages, the S corporation may be the most popular entity for small businesses. However, as an asset protection vehicle, the S corporation leaves much to be desired when compared to the limited liability company.
The primary benefits of an S corporation are that distributions made to its shareholders are not taxed at the corporate level, thereby avoiding the “double” taxation of a C corporation’s income, and are not subject to the self-employment tax. Therefore, tax advisors often advise the owners of S corporations to set their salaries at the lowest reasonable amount so as to avoid the self-employment tax on all profits paid to the shareholders in excess of their salaries. While limited liability companies also avoid double taxation of their distributions, LLC members must pay self-employment tax on the profits of the LLC (which is 15.3% of the first $94,200 and 2.9% of all profits above that amount).
Comparing the two entities strictly from a tax standpoint, then, it may appear S corporations have the advantage. However, if asset protection is a primary concern to the shareholder, the S corporation has significant drawbacks. If part of one’s asset protection plan is to have business interests owned by a limited liability company having more than one member or by a trust (in particular a foreign trust or a trust under which any person other than the grantor can receive income), then an S corporation cannot be used, since those types of entities cannot own S corporation shares.
Another disadvantage is that corporations generally require more attention to formal corporate record keeping than LLCs, thereby providing more opportunity for creditors to pierce the corporate veil if the shareholders fail to maintain comprehensive corporate records.
LLCs have a number of advantages as asset protection entities. LLC laws generally provide that a creditor of a member of an LLC is limited to a court’s “charging order” against the interest of the member to satisfy the judgment. The charging order constitutes a lien on the member’s interest in the LLC, and the court may order a foreclosure and sale of the member’s interest, which is subject to the lien. However, the LLC laws of many states provide only that the purchaser at the foreclosure sale – presumably, the creditor – will have only the rights of an assignee. An assignee does not have the rights of a partner, and cannot therefore seek judicial dissolution of the LLC and a subsequent sale of the LLC’s assets to satisfy the creditor’s judgment. The sole remedy of the creditor/assignee will be to receive its pro rata share of the distributions the LLC makes, if any.
Further, in many states, LLCs can be formed anonymously so that there is no public record of the ownership, which would otherwise permit a creditor to link the entity to the debtor. Corporations, on the other hand, must identify their officers and directors on an annual basis, thereby providing a creditor a clear trail to follow in attempting to enforce a judgment against the debtor corporation or to pierce the corporate veil and pursue the assets of a likely owner who is a director or officer.