This article covers the basic considerations that Kansas entrepreneurs should know before deciding whether to operate their business as a Kansas LLC, a Kansas corporation, or electing S corporation status. Unlike the sole proprietorship, these entities limit the personal liability of their respective owners, however, they require additional planning, formality requirements, and expenses in forming and maintaining the status of the entities.
Kansas LLC Advantages:
1. Avoidance of Double Taxation:
The most discussed advantage of LLCs over corporations is the avoidance of the “double taxation"that accompanies Kansas corporations. This not only includes dividends paid out to the corporation’s shareholders but it also includes any increases in the value of the assets held by the corporation when such assets are sold or the corporation is liquidated. By default, Kansas LLCs are treated as “pass-through” entities for tax purposes. This means that the LLC itself is not assessed any tax liability; all income, gains, losses, credits, and deductions accumulated through the business are passed directly to its members resulting in only one assessment of tax liability.
2. Charging Order Protection for Multi-Member LLCs:
In my opinion this is the single biggest advantage that an LLC can provide over a corporation. Please remember, this protection is not afforded to single member LLCs operating in Kansas. Unlike its solo version counterpart, the Kansas multi-member LLC not only provides its members with personal liability protection (assuming it was not the member's personal negligence which caused the liability) it also protects the assets held in LLC from the personal liabilities incurred individually by the owners of the LLC. LLC membership interests are considered the personal property of the LLC owners and as such can be levied against to satisfy any personal judgments ordered against the business owner. However, Kansas has limited the extent to which LLC membership interests may be used to satisfy personal obligations of the member. Under K.S.A. § 17-76, 113 a judgment creditor can only acquire the “economic” rights of an owner’s membership interest in the LLC, meaning that the creditor can collect any distributions paid out by the LLC to the individual owner to satisfy its judgment but the judgment creditor acquires no rights to participate in the management and operation of the LLC. In contrast this protection does not exist for corporate stock. This means that if a creditor successfully petitions a court to execute a writ of execution against the owner’s corporate stock with the unsatisfied amount of the judgment that not only will the creditor gain the “economic” rights of the stock, the creditor will also be entitled to all voting rights that accompany the stock. Depending on the number of shares acquired, the creditor can use these voting rights to remove the corporation’s current board of directors and implement a board of its choosing with the purpose of liquidating the corporation’s assets to satisfy the creditor’s judgment.
3. Less Formality:
Finally, in my opinion it is easier to comply with Kansas LLC formality requirements than it is to comply with Kansas corporation formalities. The LLC is designed to be managed directly by the members of the company or by a manager elected by its members. In contrast, the corporation is designed to have a three-tier management structure. The shareholders of the corporation hold annual meetings to elect the Board of Directors of the corporation who in turn govern the day-to-day business operations of the corporation through the election of corporate officers.
Kansas Corporation Advantages:
Despite the LLC advantages outlined above a Kansas corporation may make more sense for some Kansas entrepreneurs in certain situations.
1. Incentive Compensation:
Both LLCs and corporations afford the ability to offer incentive compensation programs to retain key employees by offering these employees the opportunity to acquire ownership interests in the business. However, in the case of the LLC, the proper tax treatment of these equity interests and the fiduciary obligations they create requires a more complex evaluation than which is required when issuing stock grants or options through a corporation. This is not to say, that the LLC should be completely avoided because of its complexity on this issue. The LLC in fact provides greater flexibility in tailoring an incentive compensation program because, unlike a corporation, a LLC is free to allocate ownership benefits through the discretion of an agreement rather than pro rata based on ownership percentage. With that being said, for the entrepreneur who wants a strait forward system for the distribution of ownership to the business’s key employees mainly through the use of a employee stock ownership plan (ESOP), stock options, or restricted stock then the corporation is probably a better fit.
2. Self-Employment Tax:
The existence of significant self-employment taxes could also create a situation where it is advantageous to elect subchapter S corporation status rather than operating as an LLC. In an S corp., a shareholder pays self-employment tax only on money received from the S corp. as compensation for services rendered, the shareholder DOES NOT pay self-employment tax on profits that pass through to the shareholder as a distribution. In contrast the application of self-employment tax to LLC members is somewhat in a state of flux. At one time it looked as if the IRS was going to exempt passive or limited membership interests in LLCs from self-employment taxes, however to date the IRS has not taken any affirmative steps in this direction. Therefore as the rules currently stand a member in an LLC will pay self-employment tax on the member’s entire share of LLC profits regardless of the member’s status. For the Kansas entrepreneur that desires the less formal requirements of an LLC, but also desires the reduction in self-employment taxes that a corporation offers, she or he should consider utilizing the LLC structure and voluntarily electing corporation taxation and subchapter S status through the check the box regulations.
Please keep in mind that self-employment taxes are just one consideration in a myriad of tax issues that need to be addressed when choosing the appropriate entity for a business. I personally feel the LLC is such a versatile tool that it can be molded to meet the needs of almost any entrepreneur, however, there is no bullet-proof or sure fire answer to which entity is right for you. The topics discussed above are just a few of the issues to consider when researching these entities. The decision on how to structure your business should be made with input from your business attorney and in conjunction with your tax and financial advisors.