Formation: Choice of Entity
The two most common types of legal entities are LLC’s and corporations. The three main considerations in choosing between the two relate to corporate governance, taxation and flexibility.
- Corporate Governance: Corporations are typically required to have meetings, take meeting minutes and engage in other corporate formalities. Conversely, state laws regarding governance of LLC’s are far more relaxed. For less sophisticated or smaller businesses, the greater ease of operation can be a significant consideration.
- Taxation: Although the common perception is that corporations are subject to a “double” tax, most small businesses elect to be taxed as S corporations. Similarly, LLC’s may elect either to be taxed as sole proprietorships (in the case of single member LLC’s), partnerships or S corporations. All of these options cause the business’ profit and loss to pass through to the owners and avoids the dreaded double tax associated with C corporations. The primary advantage of an S Corporation over an LLC is the ability to allocate a portion of the S Corporation’s income to the shareholders’ distributive share (rather than to wages), thus avoiding payroll taxes on that portion of the income. Generally speaking, all income generated by an LLC taxed as a partnership is subject to payroll taxes. If utilizing an S Corporation to reduce payroll taxes, surviving an IRS audit is dependent on making reasonable allocations based on the fair market value of a shareholder’s services.
- Flexibility: LLC’s allow a business to separately track an owner’s share of profit and losses, equity ownership (known as capital accounts) and voting rights. Furthermore, LLC’s are permitted to employ a wide array of economic arrangements, subject to IRS “substantial economic effect rules”. Finally, most states allow most provisions of their LLC Acts to be overridden by an LLC Operating Agreement, allowing the members of an LLC tremendous flexibility to carve out virtually any desired arrangement. Conversely, an S corporation is prohibited from having multiple classes of stock, thus requiring economic rights proportionate to share ownership and corporations in general are subject to more statutory provisions which cannot be overridden by contract.
Ultimately, the choice between an LLC and an S Corporation will depend on the facts and circumstances of each business. In cases involving complicated economic arrangements among owners, an LLC will typically be the best option. In relatively simple arrangements where payroll taxes are a major concern, an S corporation may be a better option. Nevertheless, if a business is serious about attracting investment capital from angel investors or venture capital groups, a C Corporation is typically the only option. The reasons for choosing a C corporation to attract venture capital will be the subject of another post.