When starting a new business, it’s important to have the proper legal structure in place to lay the foundation and help ensure future success. When setting up your business, how do you know which legal entity to choose? Let’s start with the basics and then highlight the advantages and disadvantages of each.
Limited Liability Company
A limited liability company (“LLC”) is a hybrid entity that takes benefits of a corporation and benefits of a partnership. That is, it protects against personal liability similar to a corporation, and has general partnership flexibility.
Advantages. There are no ownership restrictions on who may be a member and also no requirement that profits and losses get distributed to the members strictly based on their ownership percentages. For example, one member may own 15% of the company, but receive 75% of the year-end profits. An operating agreement would be drafted to allow for any disproportionate allocations decided upon by the members. Members and managers of a LLC are not required to hold regular meetings, which reduces the amount of records and paperwork needed. There are also various management options available to choose from with a LLC. It may be managed solely by the members (member-managed LLC), the members may appoint various officers or designate one or more managers (manager-managed LLC). A manager-managed LLC is similar to a corporation and its structure where the daily business is operated by the managers while the members take on a more passive role in the LLC. For tax purposes, profits and losses flow directly through the entity to the individual similarly to an S Corporation, unless the LLC chooses to elect a different tax status.
Disadvantages. In order to be treated as a partnership, an LLC must have at least two members. Although all states allow single member LLCs, the business is not permitted to elect partnership classification for federal tax purposes. From an accounting perspective, LLC’s can have complex partnership rules that may trigger many tax provisions in the operating agreement, which means ongoing compliance costs. Equity compensation in entities taxed as partnerships is much more difficult, complex and expensive to draft and administer than equity compensation in a C or S Corporation. Earnings of most members of an LLC are generally subject to self-employment tax and since a LLC is not subject to double-taxation, the profits are automatically included in a member’s income. There is a lack of uniformity among limited liability company statutes, which mean operating in more than one state may mean your LLC will be treated differently. Additionally, if you will be raising capital, you may want to consider alternatives. Although not all investors will require a C Corporation, professional investors (particularly venture capitalists) will either require or strongly prefer to invest in C Corporations. That doesn’t mean you have to start out as a C Corporation since you can always convert later if this is a requirement.
A C Corporation is a standard corporation that gives its officers, directors and shareholders limited liability. A C Corporation pays taxes at the corporate level and after that individual shareholders pay taxes on dividends paid by the corporation, which means there can be a double taxation for certain shareholders.
Advantages. C Corporations are separate entities that can sue and be sued, which shields owners and shareholders from any debts (unless you sign a personal guarantee) or lawsuits brought against the corporation. Larger companies (more than 100 shareholders), publicly traded companies and those companies seeking venture capitalist funding are typically C Corporations. There are no ownership restrictions with a C Corporation and this corporate structure allows unlimited growth potential. You can choose to also have several classes of shareholders and determine various voting rights. It is typically easier to raise capital through a C Corporation than it is for a partnership because the C Corporation can sell its stock. Since the structure of the C Corporation acts as a separate entity, the profits and losses are retained for the corporation and unless you receive a dividend as a shareholder, you will not be taxed on the income. From a tax perspective, you can deduct other business expenses and employee benefits that may benefit you or lower your tax rate by splitting profits and losses between the C Corporation and its shareholders. When a shareholder leaves or becomes disabled, the C Corporation will still continue indefinitely.
Disadvantages. Corporations have more formalities to follow, which means it can be more expensive to start. There are a number of documents that must be created and filed, including Articles of Incorporation, bylaws, minutes, etc. They will be required to hold regular shareholders’ and directors’ meetings and to keep strict records of decisions made by such parties. If you own a Corporation, your profits and losses coincide with your percentage of stock, so you don’t receive the same flexibility as you with an LLC to change the distribution of profits and losses. C Corporations cannot deduct losses on their personal tax returns because of the separate entity tax status. Additionally, double taxation is inevitable when you make distributions to a shareholder.
An S Corporation is essentially a regular corporation electing a pass through status with the IRS (for income, losses, deductions and credit). To form an S Corporation, the business must form as a regular corporation and elect the Subchapter S designation from the IRS which means profits and losses pass through to your personal tax return and you avoid the double taxation that typically occurs with a C Corporation. To qualify for S Corporation status, the corporation must meet the following requirements: (i) be a domestic corporation; (ii) have only allowable shareholders (individuals, certain trusts and estates) and cannot include partnerships, corporations or non-resident alien shareholders; (iii) have no more than 100 shareholders;(iv) have only one class of stock, and (v) not be an ineligible corporation (certain financial institutions and insurance companies cannot elect “S” status).
Advantages. So long as formalities are followed, an S Corporation is an effective shield of liability, and shareholders will only be liable for debts, obligations and liabilities of the Corporation up to the amount of their investment. Profits and losses flow through the corporate entity to shareholders. If a company does not need venture capital funding right away, it may be appealing to set up because losses can be written off on the tax returns of the shareholders up to the amount of one’s investment. Any shareholder who works for the company has to pay themselves a “reasonable salary,” which may allow for tax savings. While LLC members are subject to self-employment tax on the entire income of the business, only the wages of the S Corporation of a shareholder who is an employee will be subject to employment tax. The remaining income is treated as a distribution, which may be tax free or taxed at a lower rate.
Disadvantages. One of the biggest disadvantages of an S Corporation is the ownership limitations since shareholders may only be U.S. citizens, permanent residents or eligible trusts and estates. A shareholder must receive reasonable compensation. The IRS takes notice of shareholder red flags like low salary/high distribution combinations, and may reclassify your distributions as wages. You could pay a higher employment tax because of an audit with these results. Additionally, S Corporations are only allowed one class of stock – although S Corporations are allowed stock with different voting rights so long as the ownership of the stock is treated the same. Similar to a C Corporation, an S Corporation has Articles of Incorporation, by laws, board of directors, annual meetings, maintenance of separate bank accounts, records and books. You have 75 days after the formation of your corporation to decide about S Corporation status.
When in doubt, consult with your attorney and/or accountant to help you decide what might be best for your business.
Melody Ashby is a Senior Attorney at Meyer Law, one of the fastest growing law firms in the United States. Melody helps companies with corporate and securities matters, trademarks, contracts, employment matters and capital raises. Melody is a mentor at tech incubators and accelerators across the United States. Learn more about Meyer Law here on our website + follow us on Instagram @loveyourlawyer