Starting a new business? If so, you’ll need to decide the type of business entity it will be. Two of the most commonly selected business entities are corporations and limited liability companies (LLC). Corporations permit a business enterprise to operate independently of its ownership and affords limited liability to its owners. An LLC is a hybrid business entity that combines the flexibility of a sole proprietorship or partnership with the liability protection given by corporations. Which of these entity types to choose depends on the specific needs of the enterprise.
Considerations in Choosing Between Corporation or LLC as Business Model
1. What is limited liability?
To be liable is to be responsible for a debt. A sole proprietor is liable for the debts of the business regardless of whether the debts exceed the sole proprietor’s investment in the business. A benefit of both corporations and LLCs is that they provide limited liability; that is, the liability of a shareholder in a corporation, or a member in an LLC, is limited to the shareholder’s or member’s investment. Without limited-liability protection, an investor would be at risk of losing his or her home and all other personal assets. The limited liability protection afforded by corporations and LLCs is one of the main reasons they are so prevalent.
2. What are the formation and reporting requirements for LLCs and corporations?
In California, both corporations and LLCs are governed by state rules concerning both their formation and reporting requirements.
A corporation is formed (incorporated) by filing articles of incorporation. The corporation also creates a board of directors to oversee the corporate business and the board agrees on bylaws (operating documents). Corporations are required to hold an annual shareholder meeting each year and document the meeting’s discussion in corporate minutes.. The board of directors must convene to vote on corporate resolutions concerning any significant changes in the business. Within 90 days of filing the articles, a corporation must file an initial statement of information. The corporation is also required to file a statement of information annually thereafter.
To form an LLC, its investors or “members” must file articles of organization with the state. Then they must put together a contract called an operating agreement to use in managing the day-to-day activities and decide on each member’s percentage share of ownership. Within 90 days of filing the articles of organization, the LLC must file an initial statement of information. The LLC must then file a statement of information every two years thereafter.
Whether the formal requirements of a corporation or relative informality of the LLC is right for you will depend on the specific needs and circumstances of your enterprise. The attorneys at Bezdik Kassab can assist you in evaluating which type of organization would be the right fit for your business.
3. How are LLCs and corporations owned and managed?
A corporation may issue shares of stock in the business to raise capital. The buyers or the shareholders thereby become owners in the business. The shareholders may sell all or a portion of their shares barring any restrictions on the transfer of shares, or they may purchase additional shares from other shareholders or future corporate issues. Typically, the purchase or sale of shares by a shareholder will not affect the operations of the business, because the corporation’s management is controlled by the corporation’s board of directors, and not its shareholders. Although shareholders own the business, the business is under the control of the board of directors and the officers elected by the board (e.g., the president orchief executive officer, secretary, treasurer, etc.).
LLC members have an equity (ownership) interest in the assets of the business because they have made an investment to join the business. A member’s ownership stake, however, need not be proportionate to his or her investment; an LLC is free to bestow ownership to its members in any proportion. However, the LLC’s operating agreement may impose restrictions on ownership transfers, or may even require termination of the LLC in the event of an ownership transfer. And unlike a corporation where ownership transfers do not affect management, an LLC may be managed by its members. An LLC may also be set up to be managed by someone other than its members.
4. How are profits and losses allocated?
Corporations are separate from the owners. The corporation pays income taxes on its profits or losses, not the owners directly. Some of the corporation’s earnings may be paid to shareholders in dividends. The shareholders are responsible for the income taxes due on such dividends. Some earnings may be kept by the corporation.
LLCs, like partnerships and sole proprietorships, are pass-through entities. Pass-through businesses are those in which the profits and losses of the business pass through to the owners or shareholders. The owners pay their share of the company’s profits on their personal tax return.
5. How are LLCs and corporations taxed?
Corporations are taxed at the corporate tax rate; shareholders of corporations pay tax on dividends when they receive them. Corporations are sometimes said to have double taxation because the corporation is taxed on its net earnings and the shareholders are taxed on the dividends from those net earnings.
Regarding LLCs, the responsibility for paying federal income taxes passes through the LLC and onto the individual LLC members. Members are taxed like partners in a partnership; that is, they receive a distributive share of the profits each year and pay taxes on that share on their personal tax returns. LLCs do not pay federal income tax, only their members do.
The decision to form a business organization involves many factors – more than the five labeled here – and may not be easy. The attorneys at Bezdik Kassab are ready and able to assist you in the process.
“5 Things Considered” is Bezdik Kassab Law Group’s regular publication of legal material and analysis to assist the reader in considering various legal issue and topics. For additional information, please contact Bezdik Kassab Law Group for a no-cost consultation.
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