Selecting the legal structure for a new business has far-reaching implications, including how the organization will be managed and taxed. This post summarizes some of the legal and tax characteristics of corporations and limited liability companies, which are overwhelmingly the most common business entities.
Corporations and LLCs are created and governed under the laws of the states where they are formed. In New York, a corporation is established by filing a “certificate of incorporation” with the Department of State in Albany. An LLC must file “articles of organization” with the same agency.
Both the corporation and LLC feature “limited liability,” meaning that absent a personal guaranty, the owners are not personally liable for the business’s debts (subject to exceptions for “piercing the corporate (or LLC) veil“ if the owners use the entity to defraud or cheat creditors.
There are, however, important differences in taxation and other areas.
The Corporation
Each corporation must have stockholders who own it, directors who set policy and officers who execute that policy. These functions always exist, although in the smallest of companies, one person may be the sole stockholder, director and officer.
The governance rules for a corporation are set forth in its by-laws. It is also advisable, but not required, that the stockholders execute a stockholders agreement, which can set forth additional rights and obligations of stockholders, including rights to, and restrictions on, transferring stock.
The default tax status of a corporation is that of a “C” corporation. The corporation must pay tax on its income, and the stockholders must pay tax on the dividends and distributions they receive. This “double taxation” is a primary drawback of C corporations.
By filing a “Subchapter S election,” though, the corporation can elect flow-through taxation. The impact of the election is that the S corporation's items of income, loss, deductions and credits flow to the shareholder and are taxed only once —on the shareholder's personal return.
Statutory restrictions make the S corporation format problematic, however, to many owners. These include limitations on the number (100 maximum) and the types of stockholders (no non-resident aliens; only certain kinds of trusts). In addition, an S corporation can only have one class of stock. There cannot be common and preferred stock, although voting common stock and non-voting common stock are permissible.
This can make it difficult to separate ownership and management functions or to transfer stock for estate planning purposes. Another problem is that if a Subchapter S corporation does not distribute to its stockholders at least enough cash to enable them to pay tax on the earnings allocated to them, the stockholders may be in the unenviable position of being required to pay tax on income they did not actually receive (known as “phantom income”).
The Limited Liability Company
An LLC is owned by “members” (as opposed to stockholders), who own “membership interests” (as opposed to shares of stock). Several characteristics make it today’s “gold standard” entity.
Limited Liability: Members have the same limited liability as corporate stockholders.
“Flow-through” taxation, without the restrictions of an S corporation;
Flexibility of Ownership Structure: As many membership classes as desired, in order to create differences in voting rights, distributions and liquidation privileges.
Flexibility of Management Structure: Can be managed by members, which is similar to a partnership, or by managers who may or may not be members, which is more akin to a corporation.
New York LLCs are legally required to have a written “operating agreement,” which aligns internal structure with member needs. An operating agreement can include, among other things:
membership percentages,
members’ rights and obligations in relation to one other and the LLC,
distribution of profits,
capital contributions,
management - how policy and operational decisions will be made,
rights and restrictions on transfers of membership interests.
Those considering forming a New York LLC should be aware that they are legally required to publish notice of formation once a week for six consecutive weeks in two newspapers (one daily and one weekly) designated by the clerk of the county in which the LLC’s principal office will be located. Regrettably, the cost of publication can cause an entrepreneur to think twice about forming an LLC.
While this post has focused on legal and tax basics for corporations and LLCs, future articles will discuss structuring a business to serve operational needs and potentially different owner interests.