Business Entity Legal Structure Dilemma: Organize a LLC or Form a Corporation?

Although creating and maintaining a corporation or a limited liability company (“LLC”) will probably be more complex and costly than forming a sole proprietorship or partnership, it may be worth it for your small business depending upon the type of work you plan on doing. Perhaps the main reason you want to organize your business as an LLC or corporation is to shield yourself from any personal liability that may arise from your small business’ dealings.

Although LLCs and corporations are alike in many respects, what truly sets a corporation apart from the other types of business structures is that a corporation is its own legal and tax entity. A corporation pays its own taxes on any profits that it keeps and the owners of a corporation only pay income taxes on monies they draw from the corporation in the form of salaries, dividends and bonuses.

A LLC, just like a corporation, provides limited liability to the owners of the LLC for the business’ liabilities, including debts, judgments and others. Where the LLC differs from a corporation, however, is in terms of taxes. Unlike a corporation, a LLC is not its own, separate tax entity, and the owners of the LLC must pay personal income taxes on their share of the profits that the LLC keeps during the tax year.

Organizing your business as a corporation or a LLC makes sense in two situations. First, if the business is engaged in a dangerous activity that makes it more likely to be sued, or if the business has the potential of racking up large amounts of debt, then a corporation or a LLC may be a good idea to shield the owners from personal liability. Second, if any of the owners of a business have large amounts of personal assets that they want to shield from any potential liability associated with the business, a corporate or an LLC could be the best option.

Deciding whether or not to form a corporation or organize an LLC is an important choice to make when starting your new business or reorganizing your existing business(es). Other types of business legal structures include sole proprietorships (which are very limited in scope) and, partnerships (which do not provide the same protections from personal liability). Each legal structure has certain advantages and disadvantages. Whatever type of legal structure you decide to use, the decision ultimately should at least be based upon consideration of the below factors and a careful analysis of the nature and needs of your business. Following is a comparative discussion of certain key pros and cons of forming a corporation versus organizing an LLC.

FORMING A CORPORATION

PROS

Owner Protection from Legal Liability: Once a new business’s owner(s) successfully completes the incorporation process, the owner(s) have a limited amount of legal liability for the corporation’s business activities and debts, because in the eyes of the law the corporation is a separate entity. In order to maintain this limited liability, the corporation’s owners must follow a number of legally required corporate formalities.

Ability to Attract Large Number of Investors: The corporation’s ability to issue stock is a strong selling point to those willing to invest capital in a business venture.

Power Structure: The corporate business form has an established power and management structure – i.e., directors, officers, and shareholders. Each group has its own set of legally defined roles and responsibilities within the corporate framework. An elected Board of Directors manages the corporation’s business affairs; the officers execute the Board’s directives and run day-to-day operations. Shareholders receive reports regarding the financial status of the corporation and receive dividends without having to provide any labor or input.

Certain Benefits to Shareholders: Because of the setup of a corporation, the business will probably be able to deduct the costs of the health insurance or other paid benefits from its profits, and the benefit provided to the employee is not considered income. This is a great benefit of forming your business as a corporation. To contrast, an LLC can only deduct a portion of the cost of the health insurance (and other benefits) premiums paid for the employees.

Stock and Stock Options for Employees: Especially for larger businesses, the corporate business structure offers an appealing opportunity to retain employees and attract potential employees — stock benefits and stock options (the employee’s right to buy stock at a locked-in price).

CONS

Time and Cost of Incorporation: The incorporation process can be expensive and time-consuming. A number of documents must be prepared (including the new corporation’s articles of incorporation and bylaws), and filing and other periodic fees must be paid to your state’s Secretary of State office (or similar business filing agency).

Following Corporate Formalities: All corporations are required by law to observe a number of corporate formalities to ensure that the corporation is operating as a separate entity, independent of the business’s owners. These steps include holding regular meetings of directors, keeping records of corporate activity, and maintaining the corporation’s ongoing financial independence. Only shareholders who are also officers or directors have any role in management of the corporation. If shareholders dislike the direction the corporation is taking, it is very difficult to have any impact on changing that direction.

Potential Tax Liability: The profits from traditional corporations may be “double taxed.” That is, the corporation itself is taxed for any profits earned, and any individual stockholder who earned profits from the corporation (in the form of paid “dividends”) are also taxed. This occurs most often in larger corporations, and may not be an issue for stockholders and owners of smaller corporations, who often work for the business itself and are paid salaries (which are tax-deductible for the corporation) rather than dividends. One solution to the double-taxation problem is electing “S” corporation tax status.

ORGANIZING A LLC

PROS

Flexible and Simple Management Structure: Many small businesses may find that the flexibility and simplicity of a LLC makes it the better choice when it comes to forming as a corporation versus an LLC. The members of a limited liability company either manage the business affairs of the company themselves or appoint a manager to operate the company. No group of individuals stands between the members and the managers (like a Board of Directors in a corporation). There is a great deal of flexibility in determining a management structure for the company; and the members can adopt a structure best suited to the particular needs of the company.

No Double Taxation: A LLC may elect to be treated like a partnership for income tax purposes. If  this election is made, then all income is taxed proportionately to each of the partners who report it on their personal tax returns and the LLC is not taxed as a separate legal entity. Nevertheless, active members are subject to self-employment tax for Social Security and Medicare. If you plan on your business owning property, you will seriously want to consider forming your business as an LLC to avoid the problem of double taxes.

Versatile Tax Attributes: The business profits and losses can be allocated to the owners along different lines than ownership interest (for example, a 10% owner may be allocated 30% of the business’ profits). Owners can choose how the LLC will be taxed, either as a partnership or a corporation.

Owner Protection from Legal Liability: Owners (i.e., “members”) of the business enjoy limited liability for the business’ debts, judgments and other liabilities, even if the owners engage in significant control of the business.

CONS

Higher Costs: More expensive to establish than a sole proprietorship or partnership.

Potential Limitations on Raising Capital: Although LLCs work great when there are only a few owners of a business that expect to have a hand in the dealings of the business, the LLC structure starts lacking when the number of investors and owners increases.

Employee Retention: Unlike a LLC, a corporation has a great incentive system built directly into the structure of the business that can help small business retain great employees. Corporations can offer their best employees stock options that, in addition to providing an incentive for employees to remain with a business, also provide an incentive for an employee to continue working diligently for the business. Offering these stock options is an easier way to get employees a membership interest in the business, unlike LLCs where it can often be difficult and complex to get employees into the ownership/membership circle.

Potential Control Issues: Subject to agreement, each member may have rights in management and may contractually bind the company. The possibility of disagreement and voting deadlock exists.

STILL UNSURE ABOUT WHETHER TO INCORPORATE A CORPORATION OR FORM A LLC?

The type of legal structure you choose for your business will play a huge role in your success (or failure), so it pays to do your homework before deciding. Ultimately, you and your business associates will have to make that decision for yourselves, but Jordan Guydon LLP can help you make an informed legal and business decision and make the process as smooth as possible. Contact us for a free initial legal assessment to learn how we can help you plan for success.

WE CAN HELP!

For more information, Please call 703.865.8699 or email

eguydon@jordanguydonlaw.com or djordan@jordanguydonlaw.com or see:

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