Choosing the Right Entity: Understanding Domestic Corporations and Limited Liability Companies

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Too frequently, entrepreneurs are barely operating their businesses when they are advised that they should operate in a different form. Or, that they should have formed a corporation to save on taxes, prevent a lawsuit from affecting personal assets, or simply because that is the way business should be conducted. The result is that the business is changed to a different form, without anyone asking why the form was to be changed, what the benefits or detriments would be from making a change, and what alternative forms were available. This is a classic case of a solution in search of a problem. The purpose of this essay is to help the entrepreneur make an informed choice as to the appropriate form of business to operate. This essay considers taxation, liability, ease of operation, and ease of formation in weighing the pros and cons of a corporation versus a limited liability company. One rather common way which an entrepreneur will inadvertently change business forms is by incorporating. Very frequently, an entrepreneur will be advised that incorporating is the way people do business, or that he/she can minimize his employment taxes by taking a smaller salary and drawing the rest of his income as a dividend. Other sole proprietors will incorporate in an effort to protect personal assets. Unfortunately, many of these people know very little about why a corporation is more advantageous than other forms of business, and are often unprepared when informed that S corporations can be more advantageous than C corporations, and that a limited liability company might provide the benefits of both corporate forms with greater flexibility and ease of operation. However, the fact that a stockholder is an employee of an S corporation can restrict the relative tax advantages of the corporation. Since employment tax must be paid on the stockholder’s salary, a high-earning individual might accept an S corporation and take a low salary to avoid corporate tax, but he will end up paying a high rate because employment taxes are calculated based on a maximum income level, and S corporation status might preclude self-employment arrangements. Frustrated by this tax impact, he may dissolve the S corporation, too late realizing that the S corporation was no longer the best form of operating this kind of business.

Understanding Domestic Corporations

Thus, forming a domestic corporation brings with it more complex rules and regulations than a limited liability company. Forming a corporation typically requires much more paperwork, time, and money. The rules and regulations imposed on a corporation are usually contained in one of the most overlooked yet important documents of the corporation: its bylaws. Written to govern the internal management of the corporation, the bylaws will address many important issues regarding the corporation such as how it will conduct business, authorization of various types of contracts and agreements, internal officer and director authority, stock issuance and stockholder’s rights, and regular meeting times of the board of directors and/or stockholders. Although the corporation will be subject to many overlying state laws and regulations, it is the bylaws that will define the specific rights and duties of the various people involved with the corporation, and the specific manner in which the corporation will conduct its business. The importance of the bylaws cannot be overstated since they will have a direct impact on how successful the corporation will be and whether or not it will encounter future legal problems. Failure to prepare adequate bylaws can greatly hinder the potential success of a corporation. Bylaws, as well as the many other rules and regulations imposed on corporations, can often be complex and difficult to understand. Because of this complexity, it is recommended that a corporation consult an attorney to ensure full legal compliance and to gain a full understanding of its duties and obligations under the law. Failure of many small start-up corporations to seek proper legal advice is one of the many factors that prove to be their undoing.

Understanding Limited Liability Companies

A Limited Liability Company, often shortened as an LLC, have become the favored choice in the United States recently. An LLC is a flexible form of enterprise that blends elements of partnership and corporate structures. LLCs use the same taxation as a sole proprietor or partnership, but at the same time limits the liability of the owners to the full extent of their financial investment. This is different from a limited partnership where the limited partner loses his liability protection if he takes part in management decisions. This form of business is very flexible for it can be used in any type of business. Multi-member LLCs resemble partnerships and offer the opportunity to split profit and loss among the members in the fashion that they deem fit. LLCs can offer many options in structuring and member distributions. This is an asset for members that have specific kinds of allocations in mind when it comes to their earnings in the business. LLCs are also attractive for small businesses because they have the right to choose how they wish to be treated for tax purposes. An LLC can be a corporation, partnership, or an entity disregarded as a separate entity from the owner. This branching out in tax options can be very beneficial for a growing business with the need to change taxation status in order to maximize its benefits. Another great aspect of an LLC is the limited paperwork required to form and maintain the entity. For the long term or at the spur of the moment person trying to start up a small business, LLCs could be the best choice due to its ease in organizing and the flexibility it offers.

Factors to Consider when Choosing an Entity

LLC: As stated above, the LLC is a pass-through entity. It is taxed like a sole proprietorship or partnership. It is not taxed as a separate entity.

S Corporation: S corporations are considered pass-through entities for tax purposes. This means that the corporation’s profits/losses are passed through and reported on the individual shareholder’s tax return. The S corporation itself is not directly taxed and there is no double taxation as there is with a C corporation. An LLC shares this benefit with S corps over the C corporation in that it too is a pass-through entity for tax purposes.

Tax Implications: C Corporation: A C corporation is considered a separate taxpayer and files its own return at the corporate tax rate. If a C corporation earns profits, they are able to be distributed to shareholders in the form of dividends. Dividends are then taxed at the individual shareholder’s tax rate. This form of double taxation is a definite downside to operating in the form of a C corporation, especially in the start-up phase when profits are needed to be pumped back into the company to fuel growth. On the plus side, the corporation can write off business losses. This is in contrast to an LLC where business losses can only be written off by LLC members who actually participated in the business, up to the extent of their investment in the company.

This article has outlined the respective strengths and weaknesses of the two major limited liability entities. Making a choice between a corporation and an LLC is influenced by the desire of entrepreneurs to attain certain goals. The corporate form offers an excellent asset protection environment and unparalleled flexibility in equity ownership transfers. As illustrated in Kembell and Sydnes, corporations are often favored by companies that seek to grow through investment from outside sources. This is because venture capitalists and private equity investors are more familiar and comfortable with corporations due to their long history and relative simplicity in equity structures. This is not to say that all corporations are the same. Small scale corporations can reap many benefits by electing S Corporation status at the federal level and organize their affairs under subchapter S of the Internal Revenue Code. Unfortunately, S Corporations do not always compare favorably with LLCs and this is an issue that should be examined with a tax adviser when making a choice of entity. At the opposite end, large multinational corporations are often beset by a myriad of tax issues and the lack of a favorable tax environment may cause management to second-guess their choice of entity. Both domestic LLCs and corporations should be aware that tax planning is an ongoing process and the flexibility in entity choice often creates multiple opportunities to change or modify existing structures.