BUSINESS ENTITY CHOICE
The following is a general information letter regarding types of business entities for your review. Please review this guide and let me know which type of entity would best suit your needs. Once you have determined which type of entity would best suit your needs, I will forward to you the appropriate Questionnaire for your completion. I will then prepare the necessary documents to create your business.
What Is a Corporation?
A corporation is a legal entity that can exist separately from its owners. Creation of a corporation occurs when properly completed articles of incorporation (called a charter or certificate of incorporation in some states) are filed with the proper state authority, and all fees are paid.
What Should I Name My Corporation?
Choose the name of your corporation carefully. It is very important that you portray the image you want for your new corporation. Legally, the name you select must not be “deceptively similar” to any existing corporation or must be “distinguishable on the record” of your state. For example, if a corporation named Flower Corp. exists in your state, you probably would not be allowed to name your business Flour, Inc. It is possible that the name you select will not be available; therefore, we may ask for a second choice.
Additionally, the name you choose must show your business is incorporated. Most states require that the corporate name be followed by some type of indicator, such as Corporation, Incorporated, or an abbreviation.
What Are the Advantages of Incorporation?
One of the primary advantages of incorporation is the limited liability the corporate entity affords its shareholders. Typically, shareholders and directors are not liable for the debts and obligations of the corporation; thus, creditors will not come knocking at the door of a shareholder or director to pay debts of the corporation. In a partnership or sole proprietorship the owner’s personal assets may be used to pay debts of the business. Maintaining the limited liability of a corporation requires that the shareholders and directors follow all the rules of governance, including holding annual meetings and maintaining meeting minutes. We will send you annual reminders for these meetings and can help you prepare them.
A corporation’s life is not dependent upon its members. A corporation possesses the feature of unlimited life. If an owner dies or wishes to sell his or her interest, the corporation will continue to exist and do business.
Retirement funds and qualified retirement plans (like 401k) may be set up more easily with a corporation.
Ownership of a corporation is easily transferable.
Capital can be raised more easily through the sale of stock.
A corporation possesses centralized management.
What Are the Disadvantages of Incorporation?
The primary disadvantage to a corporation is double taxation. Profits of a corporation are taxed twice when the profits are distributed to shareholders as dividends. They are taxed first as income to the corporation, then as income to the shareholder. All reasonable business expenses such as salaries are deductions against corporate income and can minimize the double tax. However, the double tax can be eliminated by making an S corporation election which is explained in more detail below.
There is more complexity and expense with forming a corporation.
There are more extensive record keeping requirements.
Operating a corporation across state lines often requires the corporation to qualify to do business in the other state.
What Is an S Corporation?
Standard business corporations or C corporations are required to pay income tax on taxable income generated by the corporation. Making a subchapter S election by completing and filing federal Form 2553 with the IRS is a way to avoid having your corporation treated as a separately taxable entity.
An S corporation is a standard business corporation that has elected a special tax status with the IRS. This tax treatment allows the corporation not to be a separately taxable entity. Instead, the income of the corporation is treated like the income of a partnership or sole proprietorship; the income is “passed through” to the shareholders. Thus, shareholder’s individual tax returns report the income or loss generated by an S corporation.
To be classified as an S corporation, a corporation must make a timely filing of Form 2553 to the IRS. This election must be made by March 15 if the corporation is a calendar year taxpayer, in order for the election to take effect for the current tax year. A corporation may later decide to elect S corporation status, but this decision would not take effect until the following year.
In order to qualify for S corporation status, the shareholders must number fewer than 75. These shareholders must be individuals, estates or certain qualified trusts, who consent in writing to the S corporation election. The shareholders cannot be non resident aliens. Also, an S corporation cannot issue preferred shares of stock with special liquidation, dividend, or conversion rights. To compare the S corporation to the C corporation and limited liability company, view our comparison chart.
What Is the Organizational Structure of a Corporation?
The organizational structure of a corporation relies on three basic groups: shareholders, directors, and officers.
A corporation is owned by shareholders; however, they do not directly manage the corporation. Instead, they influence corporate decisions through indirect methods such as electing and removing directors, approving or disapproving amendments to the articles of incorporation and voting on major corporate issues.
The directors, who comprise the “board of directors,” are responsible for managing the affairs of the corporation. Usually, directors make only the major business decisions and supervise and appoint the officers who make the day to day business decisions of the corporation.
Officers are responsible for the everyday management of the corporation. Typically, officers are appointed directly by the board of directors.
It is important to note that a shareholder may serve on the board of directors and as an officer. In fact, in most states one person is enough to form a corporation.
How Many Directors Do I Need to Form a Corporation?
Only one director is required in most states although you can elect to have more. Some states use the number of shareholders in the corporation to determine the minimum number of directors. If the number of shareholders is three or more, then the corporation must have three directors. If the corporation has less than three shareholders, then the number of directors may equal the number of shareholders.
What Is a Limited Liability Company?
The limited liability company or LLC is not a partnership or a corporation. An LLC is a distinct type of business that offers an alternative to partnerships and corporations, by combining the corporate advantages of limited liability with the partnership advantage of pass through taxation.
What Should I Name My LLC?
Choose the name of your LLC carefully. It is very important that your name portray the image you want for your new company. Legally, the name you select must not be “deceptively similar” to any existing company or must be “distinguishable on the record” of your state.
For example, if an LLC named Flower LLC exists in your state, you probably would not be allowed to name your business Flour Limited Liability Company. It is possible that the name you select will not be available; therefore, we may ask for a second choice.
Additionally, most states require that the name you select show your business is a limited liability company, by including the words “Limited Liability Company,” or the abbreviation LLC.
How Many People Are Needed to Form an LLC?
The IRS does allow one member LLCs to qualify for pass through tax treatment; however, taxation of one person LLCs at the state level may be different.
How Is an LLC Taxed?
A state registered LLC can be taxed for federal income tax purposes as a partnership. If an LLC is not taxed as a partnership, it will be taxed at the entity level similar to a standard or C corporation.
The state income tax treatment of LLC profits and losses may or may not mirror the IRS tax treatment depending on the state.
Please note that California LLCs are subject to an annual minimum franchise tax of $800 per year. The first payment must be made within 3 months of forming your LLC. The state of California does send a bill to help you to remember to make this payment.
What Is the Organizational Structure of an LLC?
An LLC is owned by its members. They are analogous to partners in a partnership or shareholders in a corporation, depending on how the LLC is managed. A member will more closely resemble shareholders if the LLC utilizes a manager or managers, because then the members will not participate in management. If the LLC does not utilize managers, then the members will closely resemble partners because they will have a direct say in the decision making of the company.
A member’s ownership of an LLC is represented by their “interests,” just as partners have “interest” in a partnership and shareholders have stock in a corporation.
How Is an LLC Managed?
An LLC may be managed by its members (owners) or by selected managers.
If the LLC is to be managed by its members, it operates much like a partnership. Each member has an equal say in the decision making process of the company.
If the members choose, they may elect a manager or managers to act in a capacity similar to a corporation’s board of directors. These managers are in charge of the affairs of the corporation.
Member management is the normal default rule of state law. This means that if managers are not selected in the articles of organization, the members will direct the affairs of the LLC.
What Are the Advantages of an LLC?
LLCs offer numerous advantages as follows:
Pass Through Taxation
LLCs allow for pass through taxation. This means that earnings of an LLC are taxed only once. The earnings of an LLC are treated like the earnings from a partnership, sole proprietorships and most S corporations.
The LLC owner’s liability is generally limited to the amount of money which the person has invested in the LLC. Thus, LLC members are offered the same limited liability protection as a corporation’s shareholders.
Flexible Management Structure and Flexible Ownership is Permitted
Like general partnerships, LLCs are generally free to establish any organizational structure agreed on by the members. Thus, profit interests may be separated from voting interests.
What Are the Disadvantages of an LLC?
The disadvantages of an LLC include:
More Paperwork Than an Ordinary Partnership
Documents must be filed at the state level to create an LLC, which is not the case with a general partnership.
Some states require that a dissolution date be listed in the articles of organization. This date may be amended. Further, certain events, such as death of a member, a member leaving, bankruptcy, etc. can be a dissolution event. A corporation has unlimited life and these events are not dissolution events for a corporation.
Newer Entity Type
The LLC is a newer entity, and people are not as familiar with the LLC as a corporation.
Should I Choose an LLC or an S Corporation?
While the S corporation’s special tax status eliminates double taxation, it lacks the flexibility of an LLC in allocating income to the owners.
An LLC may offer several classes of membership interests while an S corporation may only have one class of stock.
Any number of individuals or entities may own interests in an LLC. However, ownership interest in an S corporation is limited to no more than 75 shareholders. Also, S corporations cannot be owned by C corporations, other S corporations, many trusts, LLCs, partnerships, or nonresident aliens. Also, LLCs are allowed to have subsidiaries without restriction.
For advice regarding which entity is best for your particular situation, please contact an accountant.