Choosing the right type of business entity is an important first step for any new start-up. It is a way to legitimize your business, and help protect it from unnecessary liabilities down the road. You might be considering forming a corporation or limited liability company (LLC), but are having trouble deciding which one to use. The ultimate decision of what business entity to use is entirely up to you, and is usually based on your management structure, financial preferences and future plans for the business. However, before you make that decision it is important to have at least a basic understanding of the differences between corporations and LLCs.
The following information is not intended as a comprehensive resource to assist in choosing a business entity, nor is it a replacement for professional counsel, but rather is a brief overview of corporations and LLC’s and the practical implications associated with both.
What Are Corporations?
A corporation a legal business entity, formed by filing Articles of Incorporation with the Secretary of State, in the state you wish to incorporate within. The Articles of Incorporation are like the birth certificate of the corporation. The owners of a corporation are known as shareholders and hold equity ownership interests known as “shares”. Corporations are legal entities, separate and distinct from their owners, and are treated as people under the law. This means that corporations can own property, file taxes, bring lawsuits, and be sued.
Limited Liability: One of the primary reasons that people choose to incorporate their business, is that a properly formed corporate business entity provides its owners with “limited liability protection.” That basically means that, so long as all of the proper formalities are adhered to, the owners of a company will not be personally liable for the debts and liabilities of the company, or its other owners. Both corporations and LLCs provide limited liability protection.
Management Structure: Corporations have a unique tripartite management structure, consisting of shareholders, directors and officers. The shareholders are the owners of the company, but don’t necessary participate in its management or operations. The primary duty of the shareholders is to elect the Board of Directors, which is charged with the overall management of the business. Some states require a minimum number of directors to serve on the board while other states do not.
Tip: Having an odd number of directors will help avoid unnecessary deadlocks when voting on key issues.
The directors then appoint officers to carry out the day-to-day operations of the corporation. Traditionally, officers include a Chief Executive Officer (CEO), which may also be called a President, a Chief Financial Officer (CFO), which may also be called a Treasurer, and a Secretary. Nowadays, there are many possible titles for C-level executives that serve as corporate officers.
Corporate Formalities: Running a business as a corporation won’t be much different than running a business under any other form. However, corporations must adhere to corporate formalities that are required by state law. Failing to do so can put the corporation at risk of losing its benefits of incorporation, primarily its ability to act as a shield of protection against any liabilities. A few primary formalities are:
- Holding annual shareholder and board meetings.
- Maintaining corporate governance documents such as bylaws and shareholder agreements.
- Maintaining corporate records such as minutes of meetings, and resolutions for acts or decisions of the board and shareholders.
- Issuing share certificates, and maintaining an accurate ledger of shares.
- Keeping personal funds and corporate funds strictly separate.
Most of your time will likely be spent running the business as normal, but from time to time you may have to follow additional steps or procedures to keep up with corporate formalities. Because of the additional corporate formalities and documents required, a corporation can cost more to form and maintain than an LLC. However, for those that are comfortable with the formalities, there are many benefits to operating a corporation.
Double Taxation: What also makes corporations unique compared to other business entities, is the way corporations are taxed. A corporation first pays tax on its earnings as an entity, and then shareholders also pay tax on profits they receive in the form of “dividends.” This is commonly known as “double taxation” and is one of the drawbacks of organizing a business as a corporation.
However, there is a possibility to organize your business as an “S-Corporation” which would allow earnings from the business to be taxed only once on the individual level. An S-corporation is a standard corporation that has chosen to be taxed under subchapter S of the Internal Revenue Code, and has shareholders report earnings on their own individual tax returns. The basic requirements to qualify as an S-corporation, the corporation must:
- Be a domestic corporation;
- Have only one class of stock; and
- Consist of 100 shareholders or less, all whom are actual individuals and U.S. residents.
There are numerous benefits and considerations of implementing a salary and profit distribution strategy, and there can be various details that can affect your tax liability. Before you choose or form a business entity, it is important to understand all legal and tax implications of doing so. With that in mind, you should consult with a tax professional to better understand the options available for your corporation and how it may affect you financially.
What Are Limited Liability Companies?
LLC’s have recently gained popularity among small businesses because they also provide adequate liability protection to their owners while simultaneously offering flexibility in management and an attractive tax set up. An LLC is like a hybrid entity that provides the liability protection of a corporation, and the management flexibility of a partnership. Depending on the plans for your business, an LLC might be the right choice for you.
Management Structure: An LLC is formed by filing Articles of Organization with the secretary of state where the LLC is being formed. The owners of an LLC are known as members. Unlike corporations, LLC’s have no strict management structure, and allows for flexibility when running the business. Generally, LLC’s are either “Member Managed,” where the LLC is managed by the owners themselves, or “Manager Managed” where the members elect Managers to run the business.
Tip: Though not legally required, most LLCs should have an Operating Agreement, establishing the LLC’s management structure, ownership, responsibilities and operational guidelines.
Less Formalities & Pass Through Taxation: Unlike corporations, LLC’s have no distinct formalities to follow while operating the business. There are no required meetings to be held, and no required records to be kept. However, in order to maintain liability protection, owners must treat the entity properly by keeping all filings current and keeping all personal and business assets strictly separate.
LLC’s are also not subject to corporate double taxation. Instead, the tax on profits of the LLC are “passed through” to the members and reported on their individual tax returns. This is similar to how the tax structure for S-corporations above, except the LLC is not required to satisfy any subchapter S requirements.
Because LLC’s require less formalities and internal documents, they tend to be less costly to form and maintain than corporations.
What Is The Right Business Entity For You?
Now that you have a basic understanding of these popular business entities, you may want to consider what really distinguishes corporations and LLC’s. The type of entity you choose will have real life implications on your business so it’s important to understand how they stack up against one another.
LLC’s Are A Fan Favorite: Initially it may seem like an LLC is the no-brainer choice. As described above, LLC’s require less paperwork, allow for greater flexibility when it comes to management, and does not incur double taxation. You might be asking yourself why anyone would ever organize their business as a corporation instead of an LLC?
Corporations Make It Easier to Seek Outside Investment: Outside investors commonly prefer to invest in corporations. Unlike corporations, LLC’s don’t have shares by default, the members simply own a percentage of equity in the company. In order to bring in an investor, the original members must give up a portion of their own equity percentages to the investor. Further, because of the flexibility in management and operational structure of LLCs, investors can be less certain of what their rights and obligations may be as an LLC member.
Alternatively, it is much easier for an outside investor to invest into a corporation. Corporations typically have a pool of un-owned authorized shares they can sell to outside investors, and the original shareholders do not have to give up their shares. Because the management structure of a corporation is more concrete and established, investors can be more certain as to their rights and obligations as a shareholder.
Choosing the right business entity to form can be an exciting prospect for any new business. Though it may seem daunting, the process does not have to be stressful. The best approach is to weight the pros and cons, consult with your financial advisor and attorney, and allow your preferences and business requirements to guide your decision.
If you have any questions about corporations, LLC’s, or any other possible business formations, contact Kohler Legal today for a free consultation with a business formation lawyer.