Choice of Entity (continued)
Corporation (this discussion assumes a traditional – “C” rather than “S” – corporation). Corporations sit at the top of the business entity pecking order, in terms of formality of internal structure and management, and legal/compliance obligations. A corporation is the best vehicle for attracting investment, particularly from a broad or sophisticated investor base. Every state has corporate statutes that clearly establish stockholders’ rights, and over the long history of corporations, a robust body of case law has developed to further flesh out investor, creditor, and other associated parties’ rights, giving comfort to these third parties in their dealings with a corporation. Moreover, a corporation may issue multiple classes and series of stocks, which appeals to private equity and venture capital investors; these investors also prefer not to invest in pass-through tax entities such as partnerships or LLCs. Additionally, for a growing company, it is much simpler to issue equity incentives (e.g., stock options) from a corporation than from an LLC or partnership. For a mature company, the repertoire of available fringe benefits can be very advantageous from an employee attraction/retention standpoint, and attractive from a tax deductibility standpoint. A corporation provides limited liability to its shareholders: e.g., if you own ten shares of IBM stock, a worst-case scenario is that the company becomes insolvent and your shares become worthless – no one will come after you personally for any liabilities of the company. However, a corporation has two major drawbacks for a small business person:
- If profitable, the owners (stockholders) of a corporation potentially face double taxation – a tax at the corporate level on the corporation’s earnings, plus a tax at the shareholder level on the corporation’s after-tax income that is actually distributed to stockholders as dividends.
- If not profitable (the case w/ most startups), any losses are trapped at the entity level and do not flow through to the owners, as they would in the other entity forms described in this article.
Formalities/Expense/Administrative Burden. A corporation is the most expensive business entity to maintain, and requires observance of the greatest formalities. A corporation must pay formation and annual fees, prepare and file a charter, draft by-laws, establish a board of directors, issue stock, conduct regular meetings of the stockholders and the board, file annual reports, and maintain corporate records. In fairness, some of these elements also attend an LLC.
Limited Liability Company. A limited liability company (“LLC”) is a hybrid entity that combines certain features of corporations and partnerships, offering limited liability protection to its investors as well as flexible economic and management arrangements and pass-through taxation. For these reasons, as well as its ease of administration due to limited formal requirements, it is often the best choice for small business owners. Like a corporation, an LLC is treated as a separate legal entity, providing limited liability to its owners (known as members), even those that participate in management; contrast this with a partnership, in which the general partners have unlimited liability. Additionally, by default an LLC is disregarded for tax purposes, avoiding double-taxation and allowing its members to apply losses toward their personal income. Like a partnership, an LLC with more than one member must file an annual profit and loss statement with the IRS, and provide another form to each partner indicating that partner’s share of the profit or loss. An LLC affords the most flexibility of any structure for implementing unusual economic arrangements – the Massachusetts statute is largely enabling in nature, allowing nearly any arrangement that the members agree to, premised to a large extent on the principles of freedom of contract. It should also be noted that an LLC can be a single-member entity, making it useful for an individual seeking asset protection, but not necessarily outside investment (e.g., it is common to form a sole-member LLC as the owner of a rental property, for liability-remoteness reasons).
Limited Liability and Post-Formation Obligations
Unfortunately, for limited liability purposes, establishing a limited liability entity (limited partnership, limited liability company, or corporation) is not the end of a founder’s “legal” obligations – a failure to conduct the business as a truly discrete entity can risk it being disregarded for tax or liability purposes – a first year law school professor would refer to this as “piercing the corporate veil.” This means that an entity, even one as flexible as an LLC, needs to keep good records and be more than an extension of its owners in the eyes of the law. The following are basic record-keeping necessities and other indicia of a valid business that will help to ensure that a legal entity’s existence is respected by the authorities:
- minutes from meetings
- a corporate record book
- use of business cards, stationery, letterhead, etc. to give notice to third parties that they are dealing with an entity and not just an individual
- a website
- separate financial records (books) and a dedicated checking account
In a nutshell: if you are going through the trouble of setting up a limited liability entity, continue to take the time to maintain its viability.
Moreover, even if a business entity is properly formed and maintained, the following caveats should be noted: (i) in Massachusetts (and most other states), professional practices, whether formed as partnerships, LLCs or corporations, cannot limit their liability for professional malpractice/misdeeds (and may also be required to purchase malpractice, or errors and omissions, insurance); and (ii) although an entity’s debt is its own, and not its owners’, in practice a lender will typically require a startup business’ owner to guarantee the debt, and hence be responsible for its repayment.
Choosing a form of organization for a business enterprise can be a daunting decision for even the savviest entrepreneur. We hope that this article serves as a good primer on the topic, and Freed Law LLC is standing by to field your questions.