Getting Back to the Basics: Choosing the Best Entity For Your New Business (Part 2): LLCs and Corporations
In our first post in this series on choosing the best entity for your new business we explored sole proprietorships and partnerships. Today’s post will highlight two additional business entities: the limited liability company (LLC) and corporation.
Flexibility is Key for the LLC
An LLC is a legal entity in which one or more individuals (“members”) have limited liability for the business’ debts and obligations even if they participate in management of the company. Members of an LLC have great flexibility in structuring the operation and management of their venture through the LLC’s governing document, known as an operating agreement. If the LLC does not draft an operating agreement, its activities will be governed by state statute.
For tax purposes, an LLC is by default a pass-through entity—i.e. any money that comes into the business will “pass-through” to the individual members of the company regardless of whether they receive distributions, and the members are required to report their share of any income on their individual tax returns. LLCs also allow the owners flexibility in setting up how the LLC will be managed, allowing either a manager-managed or member-managed entity.
To form an LLC, members are required to execute and file a certificate of formation with the Secretary of State. Though not required, members will also generally want to draft an operating agreement that includes exit strategies.
In addition to the flexibility the LLC provides in organizing and running the business, there are few administrative burdens associated with operating an LLC. Generally, the company is only required to file an annual report with the Secretary of State (and pay the associated fee) in order to maintain good standing with the state.
Formalities are Key for a Corporation
A corporation is another type of legal entity formed under state law. Corporations are a legal entity where ownership is separated from management—shareholders own the corporation and managers (commonly referred to as directors and officers) control the day-to-day operations. Neither directors and officers nor shareholders are generally personally liable for the obligations of the corporation, so long as corporate formalities are followed.
To form a corporation, incorporators are required to execute and file articles of incorporation with the Secretary of State. The corporation must create a set of bylaws that will lay out the framework for the operation and management of the corporation. The shareholders should also elect an initial board of directors and appoint officers to manage the company. Further, a shareholders agreement should be drafted to memorialize the relationship between the company and its shareholders, including (among other things) how shares can be transferred, what decisions require shareholder approval, and how or when shareholders may receive dividends from the corporation. The corporation is also required to keep record of the shareholders and their shares in a document, referred to commonly as a stock register.
From an administrative perspective, corporations are generally more burdensome to operate because of these corporate formalities, which also include the statutory requirements to hold annual shareholder meetings, maintain extensive shareholder records, and file annual reports.
Corporations are also taxed quite differently than partnerships. Corporations are subject to double taxation—i.e. money that comes into the corporation is taxed as corporate income, and the same money is taxed again when it is distributed to shareholders as dividends.
However, the corporate structure is often ideal for raising capital, and the corporate form has long been the most commonly used legal form for operating virtually all publicly held businesses.
Variations of the Corporation
S corporations are a type of corporation that allows for more flexible taxation of the earnings of owners who work day to day for the company. S corporations are subject to a number of restrictions and are generally taxed like partnerships—with one major difference—unlike in an LLC taxed as a partnership, an S corp can pay wages (as opposed to distributions) to owner employees. And, in addition to those paid employee/owner wages, the owners of an S corp are also allowed to receive dividends from the corporation. This can result in a tax savings on the employment taxes that would otherwise have been paid if the LLC were taxed as a partnership. We advise discussing your individual tax situation with your accountant to determine the best entity structure and tax election for your particular tax situation.
Nonprofit and Social Purpose Corporations
A nonprofit corporation is a legal entity typically run to further some public interest, rather than strictly for profit. The nonprofit corporation can generate revenue, but any surplus revenue must be used to further promote its public interest rather than be distributed as profit or dividends.
In Washington, you can also elect to form a social purpose corporation. This corporate entity is a hybrid between a for profit and a nonprofit corporation. The social purpose corporation is a for profit entity seeking to further a public interest. Social purpose corporations are required to file detailed annual reports defining the social purpose of the corporation and its efforts to further that purpose.
If you are thinking about forming your business as an LLC or corporation, you should consider at least your key stakeholders, each stakeholder’s goals, your tax situation, your capital requirements, how you will be perceived by the market, and your vision for your role in the market. Understanding the entity that is right for your business can be important for avoiding liability, for ensuring tax efficiency, and for ensuring your overall business success.
If you’re interested in learning more about LLCs and corporations or have questions about how to choose the right limited liability entity for your new venture, please contact us today.