When starting a business, or changing it from a sole proprietorship or partnership,* there are many things for the owner(s) to consider in their choice of entity. They range from tax treatment, to the future sale of the business, to the cost of setting it up and maintaining it. In the past, we have discussed how important the corporate shield (or veil) is in protecting your personal assets. Your choice of entity will help accomplish this protection. When choosing an entity, owners create a separate legal person and incorporate their business (often as an S Corp, but sometimes as a C Corp) or create a limited liability company (LLC). There are others. If the rules are followed, claims against the business will not reach the owner’s personal property. This means their assets usually can be taken only from their business instead of their personal assets, unless someone attempts to pierce the corporate shield. Here, we intend to give you a brief overview of the most common entities. As always, before deciding, you should talk to an attorney to go over the finer points of the decision.
*a single person ownership or if more than one, a general partnership
Some Ways in Which the LLC and the S Corp are the Same
The two most common entities to consider are Limited Liability Companies (LLCs) and Sub-chapter S Corporations (S Corps). Does one afford better protections than the other? Essentially, they offer the same protection against personal liability (but there is an interesting pair of 2012 decisions at the Massachusetts Superior Court level about the Wages Act language applying to Corporations but not to LLCs). Like shareholders in a corporation, LLC members are only liable for the amount they invest. Like an S Corp, an LLC is a pass-through entity, meaning that profits and losses go through to the LLC members who must then report the profits and/or losses on their tax returns.
How do you choose? The answers can sometimes be fairly straightforward and sometimes more complicated. Your business may qualify for one and not the other or you may need a C Corp.
Limited Liability Companies (LLCs): Some Benefits & Costs
An LLC is an entity that resembles a corporation due to the fact that it has limited liability and resembles a partnership in flexible tax treatment and accounting. With an LLC there are greater tax and accounting options than with an S Corp, and it also has more flexibility in how investments, loans and interests are treated in an operating agreement. Foreign members are also permitted, unlike with S Corps. For instance, one of our clients has a Chinese company as a member.
LLCs, such as single member ones, may be easier to set up than S Corps. Unfortunately, for multi-member LLCs, their operating agreements are more complex to spell out the relationships among members, and who and how matters are managed. Accounting costs can be higher, and the filing fees for the Certificate of Organization and annual reports fees are much higher at $500 each.
It should also be noted that LLCs in Massachusetts must indicate a lifespan. The death or bankruptcy of a member may dissolve an LLC, and when filing for one, the length of the LLC life must be declared as well. Generally, we indicate perpetual life, but the Operating Agreement often spells out conditions when a member will have its interests involuntarily terminated. Public trading options are not available for LLCs, and such plans will require a C Corp.
The S Corp: Older but Often Best for a Start Where Costs Are Key
An S Corp must be a domestic (U.S.) corporation set up under the IRS Sub-chapter S requirements. Owners may include individuals, certain trusts, and estates, but may not include partnerships, corporations or non-resident alien shareholders. An S Corp may have only one class of stock and may not have more than 100 common stockholders. Like an LLC, profits and losses pass through to the shareholders, and as such, they are taxed instead of the business.
S Corps are less costly to set up and maintain. They do, however, require regular meetings or action in place of meetings – minutes, by-laws, and other records. The filing of the initial Articles of Organization and the preparation of the votes and by-laws range from standard to tailored, and filing fees are much less costly.
The C Corp
Finally, there is the option of a C Corp. If owners plan to seek angel or venture capital funding, thus hoping to someday go public, then C Corp is the entity of choice. It has the option, but not the requirement, to later have a more complex corporate structure with different classes of stock – in addition to common stock. For angel or venture investors, for example, there could be preferred stock, sometimes with various additional protections and benefits over and above what common stockholders have. The C Corp is taxed at the corporate income level on income and then at the shareholder level, on distributions and dividends paid to them. Thus, if a new business plans to attract angel investors or venture capital, it pays to choose this form of corporate government at the outset. There may be other reasons.
Factors in Selecting Your Business Entity
The considerations discussed above are the among the basic rules and choices. There are others and we work with your accountant to try to recommend to you the best entity for now and the future. An entity may be converted in the future, but this may involve costs and tax consequences. There are others not discussed here – not for profit corporations, partnerships, and professional corporations.