Corporations

Corporations are the granddaddy of modern entities. They are often villianized, but extremely useful.

Every state has its own body of corporate law. Some tend to strongly favor shareholders, while some give more latitude to directors and officers. Many large companies, especially public ones, choose to incorporate in Delaware, largely because it has a highly developed body of case law that provides a modicum of certainty to corporate management in how to conduct their affairs. A corporation can incorporate anywhere, and register as a foreign entity in other states. However, if you are primarily intending to do business locally, you should probably consider incorporating in your home state.

Unlike a partnership, a corporation only needs one person to form. Unlike a sole proprietorship, a corporation provides limited liability and legal independence from the owner.

The biggest drawback for most business owners in forming a corporation is all the formal requirements involved. Creating—and maintaining—a corporation is substantially more involved than other forms. Some of the formalities include the following:

• The name must indicate incorporation, so it typically must have “corporation,” “company,” “limited,” or some abbreviation attached to it.

• The Articles must be filed with the Secretary of State

• An initial annual report must also be filed with the Secretary of State, and annual reports thereafter

• A board of directors must be elected, which can usually be a single individual

• The board must adopt Bylaws, which will set forth how the company is to be governed

• Stock must be issued to shareholders, which may need to be registered with the SEC through EDGAR, and possibly with the state’s securities regulator

• An annual meeting of the shareholders must be held

• The board must actually meet and keep Minutes of their meetings, even if it is a single director meeting with herself

• Shareholders must be able to inspect the books and records upon demand

• A Minute Book must usually be kept at corporate headquarters

As the business owner, it is presumed that you will sit on the Board. Anyone elected to the Board takes on great responsibility and owes a fiduciary duty to the company and to the shareholders. Directors’ business decisions are often protected by the Business Judgment Rule, but they owe a duty of loyalty, good faith, and are expected to maintain a high standard of care and skill in conducting the company’s affairs. As you think about candidates for you board, you should consider both internal constituents as well as external experts. The composition of your board should not be taken lightly. It would be wise to recruit board members experienced and connected in your industry, as well as those skilled in accounting, finance, and regulatory requirements. To avoid board gridlock, try and have an odd number on the board.

Taxation is another key consideration in choosing whether to incorporate. People speak often of the “double taxation” on corporations. This refers to the fact that the corporate entity is taxed on its income, and then that same income is taxed again when individual shareholders receive distributions.

Sophisticated companies take great pains to zero out their corporate income so that they owe little income tax. There are lots of techniques to structure transactions to minimize tax liability as much as possible. However, the United States still has the highest corporate tax rate in the civilized world. My philosophy is that corporations do not pay tax. People do. Ultimately that cost is eaten by employees, customers or shareholders. The best way to allocate where that cost goes is through careful tax planning with your accountant or tax attorney.

S Corporation

An S Corporation is like any other corporation, except it has made an election to be treated a particular way for income tax purposes. Therefore it is governed by all the usual state law requirements plus a few IRS rules.

The primary benefit for an S Corporation is the avoidance of double taxation. It is taxed as a pass-through entity, similar to a partnership. However, unlike a partnership, shareholders of S corporations do not pay self-employment tax on distributions. You do need to pay yourself a reasonable salary for any services provided to the business though. If you don’t, and you get audited, the IRS will assess self-employment tax on all distributions.

The Board—and shareholders—must elect S corporation treatment by filing Form 2553 with the IRS. The election must be made within the first two and a half months of the tax year.

There are a number of other special rules for S corporations, including:

• Election is only available to domestic corporations

• Only one class of stock is allowed

• All shareholders must be US citizens or permanent residents

• There may be no more than 100 different shareholders.

• Certain types of businesses are ineligible—such as financial institutions and insurance companies.

The drawbacks of an S corporation come from these rules. They somewhat limit your potential financing sources. Since only one class of stock allowed, you also have less flexibility than a partnership or LLC as far as allocating income and loss.

S Corps are excellent for closely held businesses that have the wherewithal to follow the required formalities.

LLC

Limited Liability Companies (LLCs) fall somewhere between corporations and partnerships. They are a relatively new invention, the first LLC Act being enacted in Wyoming in 1977. They started to become widely popular after the IRS published Revenue Ruling 88-76 in 1988, stating that Wyoming LLCs would be treated as partnerships for federal income tax purposes. More states soon enacted similar statutes, Washington in 1994.

The benefits of LLCs lie primarily in their flexibility. They provide the limited liability of a corporation, but can be taxed as a partnership, sole proprietorship, C corporation, or S corporation. Only one person is needed to form one. In most states formation is complete upon the filing of a Certificate of Incorporation and an Initial Report. The name must typically include the terms “Limited Liability Company” or “LLC.” Because LLCs have less formalities than a corporation, they can be easier to maintain.

Managerial authority is also flexible. It can either be centralized in managers (manager managed), or managed by all members (member managed). Absent an agreement to the contrary, member management is the default rule. If it is to be manager managed, this must be stated in the Certificate of Formation. If member managed, many important choices will require unanimity to decide. The more members involved, the more unruly member management will become, and the more likely you will want to designate a manager.

Some states require an Operating Agreement, but having one is highly recommended even when not required. Like a Partnership Agreement or the Bylaws of a Corporation, this is the document that sets forth the rights and obligations of the members. If more than one member is involved, the same advice for this document applies as I gave for a Partnership Agreement. It is much easier to put things in writing ahead of time, and it is usualy preferable to chose your own governance than to leave it up to statute. This is important for income and asset allocation. The Operating Agreement can even be used to define each member or manager’s standard of care and duty of loyalty to the LLC. The default will typically be a fiduciary duty.

An Operating Agreement can also dictate the life of the LLC. If there is no agreement, the life is linked to the lives of the members. As an alternative, you may want to give it a defined life with a specified dissolution date, or you may want to allow for perpetual existence. Perpetual existence may be more attractive to potential new members and investors.

The tax flexibility is the real wonder of the LLC. Single member LLCs are always taxed as though they are sole proprietorships for federal income tax purposes. However, multiple member LLCs may “check-the-box” to elect to be taxed as either a corporation or a partnership. Self-Employment Tax will depend on the structure chosen. If taxed as a partnership, members with rights and liabilities akin to limited partners may avoid self-employment tax, while those with full managerial duties and liaiblity for the debts of the partnership will be subject to it.

If the members of an LLC elect to be taxed as an S corporation, the LLC will be subject to the same IRS restrictions as an S corporation. However, owners will gain the benefit of avoiding self-employment tax on distributions.

Upkeep for an LLC is not as involved as for a Corporation. However, they do need to file annual reports and keep books and records at its principal place of business. These books and records must be available for inspection or copying at reasonable request by any member.

The primary drawbacks of the LLC are that the fees may be higher than other entities, whether for filing reports, taxes or annual levies. The case law is also much more uncertain because of the relative youth of the LLC form. Some business owners welcome working with these uncertainties. Some are less enthusiastic.

Finally, it is worth mentioning that certain types of businesses are prohibited from using LLCs, like banks and insurance companies. Professionals typically must form a PLLC, which are disallowed in certain states. For instance, lawyers cannot use a PLLC in CA.

Wrapping up

Creating an entity is an important decision for any entrepreneur, and not one to be taken lightly. It can have substantial consequences on your accounting, record keeping, taxes, ownership structure, and the management of your business.

There is no right or wrong answer. There are certain restrictions in certain industries that would make an LLC or an S corp the wrong choice, but these are the exception rather than the rule. Mostly, you need to think long and hard about how you want to run your business, how you want to structure ownership, and how diligently you are willing to follow formalities.

Shoot me an email if you want to know more about anything in particular. If you found this at all useful, share it on some kind of social media.

Drop by again soon.

Thanks for reading,

Tim