One of the most-asked questions I encounter in my practice is what type of business entity to form. This is perhaps the most consequential legal decision your business will make. The decision will hinge on a number of factors such the capital investment sought, the number of owners, the number of employees, management preferences, etc. What follows are the pros and cons of the most common business entities.
Subchapter C Corporation
Perhaps the most well-known characteristic of the corporation is limited liability. Each shareholder’s maximum liability to creditors is the value of his or her investment. In addition, ownership in a corporation is freely transferable and the life of the entity is theoretically infinite.
Structurally, all corporations include shareholders who own the equity of the corporation, but whose sole authority is to elect the board of directors. The board of directors make the essential decisions for the corporation, such as appointing corporate officers, authorizing mergers and acquisitions, authorizing issuances of stock, and petitioning for bankruptcy. This legal structure (i.e. shareholders, board, and officers) is fairly set in stone. Also set in stone are the rules governing profit sharing.
The C corporation generally is the best of the business entities to raise large sums of capital from large numbers of investors. First, there is no limit to the number of shareholders. Second, the investors have no management authority unless appointed by the board of directors to be an officer. Third, the legal structure is familiar and investors know what they’re getting into. I elaborate on this final point in my discussion below on LLCs.
The primary detriment of the C corporation is double taxation: corporations are subject to a corporate income tax for corporate income and a capital gains tax on shareholder dividends. In addition, corporations (especially C corporations) are inflexible and subject to significant IRS reporting requirements.
For these reasons, I would almost never advise a client to form a C corporation when the business will likely consist of few shareholders and moderate to low capital.
Subchapter S Corporation
S corporations differ from C corporations primarily with regard to taxation. S corporations are considered “pass-through” business entities, which means there is no corporate income tax. All income taxation takes place at the ownership level.
Further, S corporations enjoy centralized management. As stated above, this means that shareholders do not automatically have management authority in the business.
The primary obstacle faced by S corporations is that, while there is no limited to capital that an S Corporation can raise, S corporations are limited to 100 shareholders. And don’t think that you can get around this simply by placing ownership of shares in trusts or other S corporations. The IRS thought of that long ago.
Also, S corporations are limited to only one class of stock. This can be a problem if one of your biggest potential investors insists on having a higher priority in the event of a liquidation. Also, classes of shares can be assigned different voting power, which can be a defense against a hostile takeover. However, when this is a concern, I advise my clients to include in the stock purchase agreement a stock-transfer restriction. Usually these give the corporation the right of first refusal to buy back the shares at the price being offered by the third party. All that said, the restriction on stock classes is rarely a major impediment.
For these reasons, S corporations are ideal business entities for raising large amounts of capital from limited sources. However, because of the limited shareholders (who have to be individual shareholders), S corporations will never “go public”.
Limited Liability Company (LLC)
Like S corporations, LLCs receive the benefits of limited liability and pass-through taxation.
The positive qualities that distinguish the LLC from the S corporation are flexibility and operational ease. While the standard rules that apply to other business entities apply to LLCs by default, LLC owners are free to amend them. So, for example, profits and losses can be allocated among owners however they see fit. Also, the corporate requirement of a yearly shareholder’s meeting to elect a board of directors goes away, along with many other formalities that small business owners frequently fail to keep up with.
It is because of this flexibility that I recommend consulting an attorney to draft your founding documents. A commercial law attorney is especially equipped to recognize the issues and contingencies that need to be addressed. Non attorneys frequently make costly mistakes when drafting their own operating agreements—mistakes that can cost far and away more than hiring an attorney at the outset.
One drawback of the LLC sometimes is taxation. Again, S corporations and LLCs tend to attract small business owners, who, in addition to being owners, are frequently also employees of the business. Therefore, the entire income of the business can be subject to the 15% self-employment tax contributions to Medicare and Social Security. This is in addition to income taxation. On the other hand, since only wages are subject to the self-employment tax, owners of S corporations can skip much of this by receiving compensation by profit distributions rather than wages. However, one must use care in taking this approach, as employed shareholders are entitled reasonable wages.
Also, in accordance with IRS rules, an LLC can only have two of the following:
- continuity of life
- free transferability of ownership assets
- centralization of management
- limited liability
If more than two of these are present with respect to any entity, the IRS will classify that entity as a corporation.
Lastly, I would almost never recommend an LLC when the business requires significant capital investment. The primary reason is that investors can be hesitant to invest in a company with an unfamiliar structure. Again, corporations are governed by state statute and will vary little. LLCs are free to be designed (and amended) however the owners wish. This is unacceptable to many large investors.
However, most small business owners decide that the drawbacks of the LLC are significantly outweighed by the flexibility and lack of formalities. Because most business don’t receive financing from more than one or two sources, I set up more LLCs than any other business entity.
LLC Election as an S Corporation
Complicating everything, it is worth noting that LLCs can elect with the IRS to be taxed a S corporations. This is a big and complicated topic, so I will give this topic its own article.
Sole Proprietorships and Partnerships
Before the introduction of the S corporation and LLC, doing business as a sole proprietorship or as a partnership could occasionally be justified. Today it would be malpractice to advise a client to continue on in such a business.
If you aren’t doing business as a limited liability entity, you are exposing every one of your personal assets to creditors of all kinds. However, you do so without any benefit that can’t also be found in other entities. S corporations and LLCs enjoy the same single taxation as the partnership and sole proprietorship, and LLCs enjoy the same degree of management and profit-sharing flexibility.
Despite sole proprietorship and general partnerships being obsolete, I include this discussion to alert you to one very relevant issue. The Revised Uniform Partnership Act, enacted in most states, including Arkansas, defines a partnership as “an association of two or more persons to carry on as co-owners a business for profit.” This definition is spectacularly broad and has entrapped many. You will notice that nowhere in this definition is any requirement of a formal partnership agreement. As such, even a faint degree of association can suffice to make you liable for the conduct of another.
So be careful when your golfing buddy talks you into even a limited role in his “side business”.