Having practiced law within the creative industries for a number of years, I’m rarely shocked when an individual tells me that they work free-lance and have been operating without a company. That being said, there’s never a better time than now to take action! If you are individual considering starting your own company or already have a business that you operate in your personal name, the single most important first step in building a foundation for your business is choosing the proper entity. Having a good attorney and and new, easy-to-use accounting software for small businesses, makes the entire process a cinch.
As you probably know, perhaps the most popular form of business entity today is the limited liability company. However, various alternatives exist that are all worth considering. Incorporating a business, whether in one form or another, is an effective way for entities to insulate owners from personal liability, facilitate management of the business, benefit from numerous tax advantages and even take on investors.
This article sets forth the basic considerations for limited liability companies and corporations, and provides some preliminary guidance to help you as you begin planning for the growth of your business.
The Corporation
The corporation is one of the oldest and most recognized form of legal entity. Most states have an abundance of well-established laws governing the formation of and operation of a corporation. Corporations are generally favored by investors and companies with a large number of shareholders. Corporations are allowed an unlimited number of shares, shareholders and can even create different classes of ownership or “stock”. Furthermore, growing companies looking to go public or take on significant angel or venture capital investors, owners should be aware that only corporations are eligible for initial public offerings.
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Corporations, like limited liability companies, are entities which separate from their owners. Owners or “stockholders” of a corporation are generally not liable for the debts and obligations of the corporation. The incorporation process begins with the filing of the entity’s Articles of Incorporation with the Secretary of State and requires registration in any state where it is conducting business. Following filing and registration, the Board of Directors must hold an Organizational Meeting where the Board will select officers, adopt bylaws, and conduct other appropriate business.
Most states do not have rules that require a minimum number of owners that a corporations must have, but rather a single person is capable of being the director, officer, and shareholder of the company. Corporations have a three-tiered management structure. Officers, who run the day to day operations of the company report to the Directors, who are responsible for overseeing the fundamental decisions. Directors act in the interest in of the stockholders in overseeing fundamental business decisions. Different classes of stock (i.e. common and preferred) and voting rights for each class, are generally set forth in the corporations Shareholder’s Agreement, Bylaws and Articles of Incorporation, to which all the shareholders are bound. It is important to note that all decision making between the directors, officers, and shareholders may be modified by a Shareholder’s Agreement. Shareholders’ Agreements can also provide for a number of other complex rights and restrictions on ownership of the Company, but we’ll save some of the more complex matters for another article.
Generally, we refer to plain, vanilla corporations as “C-Corp”. What many entrepreneurs don’t know is that corporations can elect taxation under Subchapter-S of the Internal Revenue Code (creating what’s called an “S-Corp”). A corporation that does not elect S-Corp status is taxed separately from its owners, typically between 20 and 40 percent on its net income, which takes into account state franchise taxes assessed to the corporation. When a corporation decides to issue dividends to its owners, each dividend is subject to taxation as well, which is why these entities are often referred to as “double-taxed.”
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However, a corporation may avoid the “double-tax” by filing as an S corporation. Similar to partnerships, S corporations are pass-through entities that do not pay income taxes at the corporate level, but only at the individual owner’s level when income is allocated among owners. In order to qualify as an S corporation, there can be no more than 100 shareholders, all shareholders must be individuals and generally must be U.S. Citizens or Green Card holders.
The Limited Liability Company
In recent years, the development of the limited liability company (“LLC”) has changed how many business are structured. The LLC is a hybrid legal entity that adopts many of the features of the corporation as well as traditional rules regarding partnerships. The LLC is becoming increasingly popular because it offers limited liability to its members for all of the LLC’s obligations as well as tremendous flexibility in its ownership structure.
LLCs are formed by filing the Articles of Organization with the state in which the LLC does business, which include similar information to a corporation’s Articles of Incorporation. Due to the fact that the laws surrounding LLCs are not as developed as corporation rules, most states require that LLC’s have Operating Agreement. An Operating Agreement is signed by an LLC’s owners or “members”, is drafted to structure an LLC’s financial and functional decisions and provide rules and regulations governing the transfer of ownership, addition of new owners, tax rules and decision making authority. Additionally, the Operating Agreement outlines how profits and losses will be distributed and how and when meetings will take place, and govern succession planning, such as procedures agreed upon for buying out or transferring ownership interests when members leave the LLC. Unlike corporations, LLCs do not have a formal management structure and can tailor their Operating Agreements to fit the business’s organizational needs. An LLC can have different classes of members making the business form flexible in management, financing, and operational aspects. A properly tailored Operating Agreement can save a lot of headaches in the future.
What many people do not know, is that the LLC, unlike the corporation, is the most flexible entity for tax purposes and may elect to be taxed as a corporation, an S-Corp or as a partnership. By default, LLCs are taxed as a partnership (unless another election is made). Accordingly, all profits and losses of the partners in a partnership.
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