Choice of Business Entity: Corporate Form vs. LLC

When an entrepreneur plans to start a new business, several fundamental factors must be considered. Each of these fundamental factors is essential to the success of a business. However, an appropriate structure is the best first step.

Before deciding which ownership structure will be most appropriate for you - a sole proprietorship, a partnership (limited or general), a corporation (C corporation or S corporation) or a limited liability company (LLC) - you must first decide where you want to grow. A sole proprietorship is the simplest of all of these entities, but provides the least amount of protection for its owners. A sole proprietorship may be the most appropriate business form if your business is relatively small, non-diversified, has modest profits, and is not likely to expand significantly in the immediate future. However, even a small business might consider electing S corporation status for advantageous tax treatment. If your business is larger, has greater investment needs but few owners and has a low risk of liability, the most appropriate form may be a partnership. When the business is expanding, becoming more profitable and diversified, it may be most advantageous to choose the corporate structure. If your main concern is limiting your personal liability for business debts, limited liability companies may be the choice. This article focuses on the characteristics; the advantages and disadvantages particularly associated with California corporations and limited liability companies (LLC).

The most important feature of a corporation is that it is a separate legal entity from its owners and operators. Corporations consist of shareholders who are the owners of the business, a Board of Directors who are elected by the shareholders to manage the business, and employed officers who are elected by the Board to oversee day-to-day operations. In most states, including California, one or more persons may form and operate a corporation. As a separate legal entity, a corporation is capable of continuing indefinitely. Its existence is not affected by death or incapacity of its shareholders, officers, or directors or by any transfers of its shares. To form a general C-Corporation, an Incorporator must file Articles of Incorporation and pay the requisite state fees and any prepaid taxes with the Secretary of State. A properly formed C-corporation pays taxes at its own income tax rates and files its own corporate tax forms each year.

One of the key advantages of the C-corporate form of business is that the liability of its shareholders is limited to their investments. Their personal estates are usually not liable for the obligations of the corporation. However, corporate formalities required by California must be followed; otherwise, a court or the IRS may “pierce the corporate veil” and hold shareholders personally liable for corporate debts. A key disadvantage of the C-corporate form is that any distributed corporate income is taxed twice. The corporate entity pays taxes on the corporation’s income, and when income is distributed to shareholders, the shareholders again pay taxes on that income. However, in most small or closely held corporations, this “double taxation” dilemma will rarely occur.

Some small corporations are able to avoid the double taxation problem of C-corporations by paying no corporate federal income tax or state corporate franchise tax when it qualifies and elects to be an "S-Corporation Status" by submitting IRS form 2553 to the Internal Revenue Service. Subchapter S of the Internal Revenue Code allows qualifying corporations to be taxed in a way similar to the way a partnership is taxed; that is, the income is taxed only once-when it is distributed to the shareholders-owners. This is known as “pass through” taxation. To qualify for the S election, the corporation must be a domestic corporation, have only one class of stock, and have 75 or fewer individual shareholders who are not nonresident aliens. Members of affiliated groups, certain financial institutions, insurance companies, possessions’ corporations, and domestic international sales corporations are not eligible to be S-corporations.

An S-corporation status is advantageous, if a corporation has losses, and if the shareholders have a sufficient basis in their stock to permit a deduction and a sufficient taxable income to benefit from the losses. Also, if a corporation is profitable and does not need to accumulate additional capital, an S corporation status may be elected. Lastly, an S corporation is appropriate if the shareholders wish to have the corporation’s earnings distributed to them at only one level of taxation when there is a potential accumulated-earnings problem.

However, an S-corporation's taxable income or loss for the current tax year is taken into account pro rata by the shareholders on their individual returns regardless of whether the corporation actually distributes that income to its shareholders. Therefore, if one plans on drawing a very low salary and leaving most of the corporate earnings in the corporation for re-investment, the S-corporation may not be the solution. Furthermore, S-corporations are limited in terms of the amount of deductions for fringe benefits such as health insurance. An S-corporation cannot deduct such benefits for an owner-employee who owns 2% or more of the corporate stock while a C-corporation can do so for all owner-employees. Lastly, the IRS may terminate an S-corporation status if the corporation claims income from a passive investment, such as real estate owned, for three consecutive years that exceeds 25% of its gross receipts. For this reason, most real estate investors prefer placing real property in a limited liability company (LLC) rather than an S-corporation.

If it is limited liability that one wants, an LLC provides the same protection as does a corporation, but the simplicity and flexibility offered by LLCs offer a clear advantage over corporations. In general, an LLC is a hybrid form of business enterprise that offers the limited liability of the corporation but the tax advantages of a partnership. The major advantage of an LLC is, of course, that it is not taxed separately from its members. The members declare company income or loss on their individual income tax returns - the same pass through treatment afforded S-corporations and partnerships alike. Moreover, an LLC is recognized as a separate legal entity from its members. Ordinarily, members are not personally liable for the debts and obligations of the limited liability company. However, there are some exceptions where individual members may be held liable, such as a guarantor liability where an LLC member has personally guaranteed the obligations of the LLC.

Unlike S-corporations, LLCs may have an unlimited number of members. A LLC is advantageous in that individuals, corporations, partnerships, trusts and even non-resident aliens may be members or owners. Members of an LLC usually own and manage the business. Most states, including California, allow a single person to operate as a limited liability company. One disadvantage of the LLC is its transferability. No one can become a member of an LLC (either by transfer of an existing membership or a new issuance) without the consent of members having a majority in interest unless the articles of organization provide otherwise. Furthermore, while a corporation can exist forever, an LLC does not necessarily have a continuity of existence. The Articles of Organization filed with the Secretary of State or the operating agreement may specify the latest date at which the LLC is to dissolve.

While LLCs are more flexible and less formal than the corporate form, they are a relatively new business entity in California. As such, California does not allow any professional requiring a license to form a LLC. Examples of such professions include general contractors, doctors, lawyers, real estate agents and certified financial planners. Therefore, those wishing to start a business in a profession requiring a license are limited to the corporate form, partnerships or sole proprietorships.

When deciding which business structure is most appropriate for a particular business, one needs to consider the business’ potential liabilities, the formalities and expenses for the establishment and maintenance of the business, its income tax situation and capital needs. The initial choice of an ownership structure can be converted to another more suitable form later if the business situation changes. However, planning for the future of the business should begin as early as possible to avoid added expense or risk.

LaFlam Sullivan can help you identify, plan for and carry out all of your business’ fundamental needs so that you may focus on growing your business.