Benefits of LLC vs Corporation
You have now readied your team to tackle the issues of starting your new company. You have found a small business attorney to help guide you through some of the legal issues your startup is going to face. You have a dynamite name and you have commanded your startup attorney to file the papers to register your new business. But just hold on there. Your attorney has to go over with you the various corporate forms that are available and particularly corporations vs. LLCs (limited liability companies). There are numerous considerations for choosing the corporate form for your new business. They generally fall into four major categories:
1. Protecting personal assets: the business owner wants to assure that the new business’ creditors can only get at the assets of the business, not those of the individual owners;
2. Transferring interests in the business: whatever form you have, you want to be able to transfer stock, or ownership interests in your business;
3. Admitting new investors: you want to make sure that you have a mechanism to admit or restrict new investors in the business;
4. Taxes: which corporate form allows you to pay the least amount of taxes.
In this blog post, I am going to focus on two of the most common forms available for small businesses: S corporations named after subchapter S in the tax code, and limited liability companies (LLCs). Your startup attorney may suggest that you look at the S corporation and LLC as the two most attractive options. I will first explain why other forms of doing business are not generally as attractive to the small business owner as a LLC or S corporation.
Other less attractive forms of business for the startup business
When you are deciding forming your business as a LLC or corporation, you will also consider other forms of business. In this section, I outline some of these other forms of business and discuss whey generally startups opt of a LLC or corporation.
Sole proprietorship exposes your personal assets to the small business’ creditors. If you are conducting business as a sole proprietorship, you are exposing your personal assets to the creditors of your business. It is not likely that this form of conducting business will be the most appropriate form for your startup. You may want to own real property in your own name so that you can obtain more favorable terms for a loan or because of the transfer taxes to put the property into a LLC. If you make a decision to own your business as a sole proprietorship, you should be advised to purchase higher limits on the liability policy and obtain an umbrella policy.
C corporations generally required for outside investors. For most startups, a C corporation is not an attractive option because of the double taxation at the corporate and individual level. The corporation pays taxes on the net profit and the shareholders pay taxes on dividends. There are certain benefits such as the deductibility of certain expenses, but for the most part a startup is not going to organize as a C corporation, unless its investors require an investment in a C corporation. If you are planning on going public (you can hope), then a C corporation may be one of the forms of doing business that you want to look at. Remember that even if you choose a limited liability company or S corporation, you can convert to a C corporation if you need to later on.
Partnerships rarely used. Limited or general partnerships used to be the form of choice in the 1970s and 1980s before the advent of the limited liability company. They still survive from those days although it is rare that a startup would want to use a partnership as a form of business. Whether it is a general or limited partnership, one partner is on the hook for the liabilities of the business. In a general partnership, all of the partners are liable for the debts of the company and in a limited partnership, the general partner is liable for the debts of the company. An LLC can provide better protection than a partnership and still take the benefit of partnership taxation.
Organizational considerations for S corporation
The discussion with your startup attorney may be very quick once you learn that there are restrictions on whether you can organize as a S corporation or whether you can elect to have your LLC taxed as a S corporation. The first questions is whether your startup is eligible to be taxed as a S corporation. You may not be able to get off of first base if you are intent in forming a business that may be ineligible for treatment as a S corporation. The major impediments are as follows:
1. No more than 100 shareholders. If you have many shareholders, then you will not be eligible for sub S treatment.
2. Non-resident aliens. At Rosten Law located in Washington, DC, we have clients who are not U.S. citizens or do not live permanently in the United States. There may be some lawyers who would recommend limiting the members of sub S corporations to citizens, although not technically required, under the rationale of what happens if your stockholder, a French national with a green card, decides that she is disgusted with the horrible cuisine in the United States and decides to return to France, or threatens to leave the country to leverage her bargaining position in the company.
3. Only one class of stock. Suppose that you want two classes of stock, one for those who received a preferred distribution ahead of other members, and those who do not receive a preferred distribution. Since the members have unequal rights to distributions, your company is ineligible for treatment as a subchapter S corporation.
4. No corporate shareholders. Another show-stopper is if you want a corporation or partnership to own the business. S corporations require ownership to be held by individuals, estates, certain trusts or charitable organizations.
If you can overcome these constraints, then you have some further options that you may want to explore. If you are the sole owner of the startup business, and want to take advantage of the corporate form, you can organize as LLC and be taxed as a sole proprietorship. Your LLC will be considered a “disregarded entity” and the profits and losses will be reported on your individual tax return. You can also elect to be taxed as a S corporation if you meet the criteria. There may be some tax reasons that you may want to be taxed as a S corporation. I will discuss those tax reasons in the next blog post.
If you have multiple owners, then you can organize as a S corporation or a LLC. If you decide that you want the LLC, then you need to decide whether the LLC will be taxed as a S corporation, assuming you meet the requirements, or a partnership.
Corporate formalities: limited liability companies more flexible
In general, from a tax perspective, there is no difference if you organize your small business as a S corporation or as a LLC and then elect (by filing IRS Form 2253) and “check the box” to have the LLC taxed as a S corporation. There is a difference if you organize your startup as a subchapter S versus a LLC. A sub S is still a corporation and you will need to comply with the corporate formalities such as board meetings, minutes, resolutions.
If you have a corporation, regardless of whether it is a S corporation or a C corporation your company still needs to comply the formalities of a corporation according to the law of the state in which the company is incorporated. That means that the shareholders elect the board of directors, who in turn appoint the executives or officers of the company. The company officers are in charge of the corporation’s daily activities.
There are certain procedures spelled out in the bylaws that govern shareholder and director meetings. The corporation must maintain books, records of account and minutes. In a limited liability company, there are few legal requirements other than what is provided for in the LLC operating agreement. If the new business is organized as a subchapter S corporation, then it must comply with these formalities. If it is organized as LLC and then elects to be taxed as a S corporation, then the procedures are enumerated in the LLC operating agreement.
Some companies like the discipline imposed on the managers to have a corporate structure. For others, the less formal requirements of a LLC suit their needs. Also, remember that it is easier to convert a sub S to a C corporation once you have investors who are willing to invest and may require a C corporate structure. A S corporation issues stock that is freely transferable if there are no shareholder agreements in place. Usually a LLC operating agreement places restrictions on the transferability of the membership interests in the LLC.
New business owners generally like the flexibility of the limited liability company over a corporation. In the next blog post, I will discuss the major considerations of deciding between whether your new limited liability company should be taxed as a S corporation or a partnership.