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Does an S Corporation Provide Better Limited Liability Protection Than an LLC?

Many people seem to think that an S corporation offers better legal protection than something like limited liability company. But this assumption is wrong--and for at least two reasons.

The first reason that this idea is wrong is that an S corporation is not real corporation. An S corporation is a fiction of federal tax law. Really, when you boil everything down to its essence, an S corporation is just a set of tax accounting rules. And many entities can use the S corporation tax accounting rules: corporations, limited liability companies, and a whole bunch of other entities as well.

The bottom line, therefore, is that an S corporation absolutely does not offer extra legal liability protection. The S corporation accounting methods provide many wonderful benefits... but extra legal protection is not one of these benefits.

Let me also, though, talk about the second reason this trash-talking of the LLC option is wrong. As a practical matter, a limited liability company almost surely offers small business owners and investors better legal protection that the alternative--which would be a regular, traditional corporation.

Limited liability companies arguably offer better limited liability protection because of a couple of really significant factors. The first factor is that a limited liability company requires far less formal governance. A limited liability company, for example, doesn't require annual shareholders meetings, a board of directors, and regular (perhaps monthly or quarterly) board of directors' meetings. No way. Limited liability companies were designed by state legislatures to be "light" versions of the traditional corporation. By design, the limited liability feature of LLCs is supposed to be harder for small businesses and investors to screw up. All the LLC and its members really need to do is have and follow an operating agreement.

A second factor may also give LLC owners in many states better legal protection. But let me explain. In some states, owning an interest (shares) in a limited liability company is actually safer than owning stock in a small business corporation. In many states, creditors can gain ownership of your shares in a small business corporation (and therefore can control the corporation). But in many states creditors cannot gain ownership of your interest in an LLC. In these states, a court can tell the LLC to redirect distributions that would normally go to the LLC member to some creditor of the LLC member. But this ability--called a "charging order"--still gives the LLC and its member tremendous protection and negotiating leverage.

Note: While I recommend most small business owners use an LLC as the platform for an S corporation for the reasons just given, the individual pages selling do-it-yourself S corporation kits provide two versions of the kit. One version builds an S corporation on top of a limited liability company. The other version of the kit builds an S corporation on top of traditional or regular corporation.

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