Business Entities 101
by James Chenoweth Not long ago, a relative of mine asked me for the best way to set up a small business. The question he asked, basically, was would he prefer a Limited Liability Company (LLC) or a corporation that gets to file under subchapter S of the Internal Revenue Code (an S-Corp). If you don't understand these terms, that is okay, I will give you a brief synopsis.
Businesses are structured certain ways for two primary reasons. First, to give limited liability to investors; and second, to avoid paying the extra corporate tax, in addition to the tax on individuals. Traditionally, there existed two basic structures, the partnership and the corporation. A partnership would avoid the corporate tax, meaning profits were only taxed at the individual partner's level. However, each partner was responsible for the debts of the partnership, so if someone sued the partnership, the plaintiff could acquire the assets of the partners, once the partnership's assets were consumed. The corporation did not have this feature, rather had "limited liability," meaning the shareholders were not responsible beyond their investment (i.e. whatever they paid for their stock). The disadvantage of the corporation, then, was that it was taxed at the corporate and shareholder level, once the shareholder received dividends.
Enter the S-Corp. In an effort to support small businesses, the federal tax system to change to allow certain corporations to avoid the corporate taxes. This gave the state-level benefit of being a corporation with limited liability with the federal benefit of avoidance of taxes - the best of both worlds. The requirements to qualify for this "partnership" tax treatment are below.
Enter the LLC. Typically, to receive limited liability, you would have to file a corporate charter and pay a fee with the secretary of your state. Very recently, states have begun to recognize limited liability for unincorporated entities, and the federal government has done nothing to tax these LLCs.
Limited Liability Company (LLC)
The LLC provides the liability protection of a corporation with the tax treatment of a partnership. Although the federal government will not tax these entities with the corporate tax, some states that have state corporate income taxes do not.
An LLC can have an unlimited number of shareholders (how you solicit these shareholders, however, will bring you into conflict with SEC rules, which will undoubtedly be the topic of a future LegalBits). In addition, the LLC can have many different classes of interest (shares), including contingent interests like options and stocks that later vest. This flexibility provides you with the ability to offer stock options to employees as a productivity incentive.
The LLC also makes a great structure for a start up company, because directors (members of management) can take losses at your personal level. A start up will likely have many losses at the beginning of the company's life. Non-managerial investors may only take losses on "passive income" (this is like rents, see the IRS regulations).
Certain events, like the death of an investor, may cause an LLC to dissolve in your state unless you put provisions in your LLC Agreement. In addition, interests (shares) cannot be transferred without approval of other LLC members. This is a problem that typically exists in partnerships, as well.
You form an LLC usually with a certificate under state law. Some states require publication of the certificate. An additional flexibility with the LLC exists in its ability to change to another form. Although you could not go IPO with an LLC structure, you can convert your LLC to a corporation without recognizing gain for tax purposes. This is a benefit over the corporation as a start up, because you may not turn a corporation into an LLC without recognizing the gains.
The S Corporation (S-Corp)
The S-Corp comes with the same limited liability and "pass-through" (partnership) tax treatment. It is formed by filing with the state and paying a fee, and you can form in any state you want, regardless of whether you have any business there. Many choose to incorporate in Delaware because the law of corporations is very well settled and pro-management there.
I'll make this very simple. It makes no sense to choose an S-Corp over an LLC, because the only real benefit the S-Corp has over the LLC is that it is easier to form. It is cheaper to form because you won't need to pay a lawyer to draft an LLC Agreement. However, if you are going to start a business, this initial cost should be the least of your worries, and the disadvantages of the S-Corp are many.
First, the IRS limits who can be a shareholder in an S-Corp. They must all be US citizens, whereas an LLC can have any investor it wishes. In addition, the shareholders of S-Corps can only be actual people as opposed to other entities like partnerships and other corporations. This restriction severely constrains your capital-raising ability as an entrepreneur. Also, the S-Corp is limited to 75 shareholders, and there can only be ONE type of stock, which means no options priced at a lower price than market value of the stock. You can have different classes for voting, but you may not have preferred interests (i.e. where one class is paid out first).
The S-Corp has a perpetual existence, unlike the LLC in some states, which will dissolve the entity in instances of death or bankruptcy of a shareholder. In addition, interests in an S-Corp are fully transferable without other shareholder approval.
An S-Corp may not own more than 80% of another corporation. An LLC can have whatever holdings it wishes.
One final benefit of the S-Corp over the LLC is that all investors may take the losses of the S-Corp, as opposed to simply management in the LLC.
Conclusion
When it comes down to it, you are concerned with limited liability and tax treatment. Remember that you may not always want "pass-through" tax treatment, because at the beginning you may take on a lot of loss carry forwards that have value. You also want to consider the flexibility of the capital structure, so that you can issue many classes of securities to accommodate different shareholders. Obviously, you also need to contact a trusted attorney or financial advisor. An attorney may accept stock as payment, so do not hesitate to contact one. ----------------------
Disclaimer... My articles / essays are intended for entertainment only. I am not a lawyer or expert of any kind or in any field and do not hold myself out to be. NetNacs, its owners, its affiliates, and I do not guarantee the accuracy of any of the claims made in my articles / essays at any time. Please consult your legal or financial advisor for professional advice on the subjects of my articles / essays. NetNacs, its owners, its affiliates, and I disclaim all liability as a result of any action taken based on my articles / essays. |
