There are many things to consider when starting a business. From branding to sourcing suppliers to analyzing the competition, you have a lot to cover. First, consider how critical it is to choose the right business entity that meets your goals. Properly structuring your business from the beginning helps avoid future headaches and mitigates expenses. Therefore, one of the first things you should consider is which business entity to operate under.
When doing business in the United States, it’s important to separate you from your business in order to protect yourself from liability. A business entity is an artificial organization created to conduct business and separates an individual from their business.
There are many business entities to choose from, all with unique advantages and disadvantages. The two most common business entities are a limited liability company (LLC) and a corporation. Now, which one is best? The answer to that question depends on many factors.
Formation & Ownership
Both LLCs and corporations are formed in the same way. You must file organizational papers with a state’s Secretary of State to start. These organizational papers are called "articles of incorporation" for corporations and "articles of organization" for LLCs. Which state you select depends on where you want your business to be organized in.
Corporations offer protection for individuals and allow for the opportunity to raise capital through the public markets. However, corporations have a lot of formalities, resulting in more expenses. This may not be ideal for a small business. LLCs have less formalities but still offer the same protection as corporations. Most small businesses are formed as an LLC because they don’t need access to public investments.
Ownership of a corporation is represented by shares, while ownership of an LLC is represented by a membership interest. Membership interests are expressed as a percentage by default but can be elected to operate more like a share of stock (i.e., be represented in units).
Corporations are managed by a board of directors, elected by owners (called “shareholders”). The corporation sets the number of people on the board. This structure is referred to as centralized management. The board appoints officers to run the business, subject to the board’s oversight.
Corporations have two main governing documents, the charter or articles of incorporation and the bylaws. A corporate charter, among other things, specifies the corporation’s name, the types of stock it’s authorized to issue, and rights and preferences. A corporations bylaws specify rules regarding governance of the corporation, such as voting standards and shareholder meetings.
LLCs can be member-managed or manager-managed. Member-managed is similar to a partnership or decentralized management. Here, members have the authority to manage the LLC through voting. In most states, the default rule is that voting is based on the percentage of ownership. This default rule can be changed by electing a different method in the Operating Agreement (also known as an LLC Agreement).
The Operating Agreement is the main governing document for an LLC and is a contract that is entered into between the owners of the LLC (called “members”) which addresses management structure, allocation of profits and losses among the members, member taxation, and more. Oral or implied Operating Agreements can become problematic. Thus, it is best to formalize the Operating Agreement in a written agreement. Operating Agreements are used in both member-managed and manager-managed LLCs.
Manager-managed LLCs are similar to a corporation or centralized management. Management authority vests in the board of managers, which the LLC members elect. The removal of managers is provided for in the Operating Agreement. The Operating Agreement is analogous to a partnership agreement if the LLC is member-managed, or a combination of a corporate charter and bylaws if the LLC is manager-managed.
Liability and Taxes
A corporation is governed by the law of the state in which it’s incorporated. A corporation offers its shareholders a full liability shield. This means that shareholders will not be held personally liable for the debts or obligations of the corporation, with some exceptions. However, if the corporation fails, the shareholder will lose what they paid for the shares. An example of a situation where a shareholder can be held personally liable for the corporation’s acts would be when a shareholder acts in his or her own self-interest to the detriment of the company.
A corporation is taxed under Subchapter-C for federal income tax purposes unless it has elected to be taxed as a “small business corporation” under Subchapter-S. A corporation that is taxed under Subchapter-C is called a C-corporation. A corporation taxed under Subchapter-S is referred to as an S-corporation.
A C-corporation is considered a separate taxpaying entity. It must file an annual income tax return and pay any resulting income tax at corporate income tax rates. If a C-corporation distributes money to its shareholders, the shareholders must include the distribution in their taxable income. Thus, corporation profits are taxed when earned and taxed again when distributed to shareholders.
An S-corporation is taxed similar to a partnership. Like a partnership, an S-corporation isn’t required to pay federal income tax. Instead, S-corporations pass its profit and losses through to its shareholders pursuant to their ownership percentage. Each shareholder then reports their share of the profits and losses on their personal federal income tax return.
LLCs on the other hand, are a relatively new entity type. They are a hybrid between a partnership and a corporation. LLCs offer the best of both worlds; LLCs have the liability protection that corporations offer but have pass-through taxation like a partnership. Like an S-corporation, LLCs are not required to pay federal income tax. Instead, the profits and losses are allocated to the members pursuant to the Operating Agreement. Each member then reports their share of the profits and losses on their personal federal income tax return, just like an S-corporation.
Like a corporation, LLCs provide their members with a full liability shield. This means that a member is not personally liable for the debts or obligations of the LLC. If an LLC fails, a member will likely lose what they paid for their membership interest, but the member’s personal assets are protected. Of course, there are situations where a member’s personal assets can be at stake, just like the example mentioned above for shareholders of a corporation.
Committing to an entity to operate under is a comprehensive decision. It’s important to look at every situation differently and act accordingly. This provides a high-level overview of things to consider, but we understand it can be confusing when selecting which business entity to form under.
Contact Jabbour Law today to see how we can help you structure your business.