May 2016

Analyzing the Classic Business Formation Question: LLC or Corporation

By Sam Mazzeo

Wilkinson Mazzeo PC

Advising clients on choosing between a Limited Liability Company (“LLC”) or a Corporation for their new (or existing) business can be challenging. Here is a quick and easy roadmap to help guide you through that conversation:

1. For Less Paperwork, Choose an LLC

States require various documents to set up both LLCs and corporations.  The requirements vary from state to state, but on average, corporations usually require more documents both during incorporation and throughout their existence. If keeping up with filings is a concern for your client, it would likely be a better fit to choose a LLC. Of course, this is not the only consideration.

LLCs must file Articles of Organization and, while not technically required in most states, it is strongly encouraged for LLCs to also have an Operating Agreement. For example, in California it is a statutory requirement. See California Cal. Corp. Code § 17701.01, et. Seq. Comparatively, in Delaware, an operating agreement can be oral or non-existent. See DEL. CODE. ANN. tit. 6, § 18-101.

Similarly to LLCs, corporations must file Articles of Incorporation. Where the extra paperwork comes in is with new corporations, which are required to be governed with written Bylaws, usually must issue stock certificates, and enter into Shareholder Agreements or Buy-Sell Agreements. See Cal. Corp. Code § 200.5. Even in states where these additional documents are not required, the documents are recommended for guidance in the event of any dispute or disagreement. Corporations are also required to hold annual board meetings and shareholder meetings where decisions can only be made if a quorum is present.  See Cal. Corp. Code § 600. The corporation must also record and file minutes from these meetings. Id.  With all of these extra corporate formalities, it typically takes less time to create and maintain an LLC, which means lower legal fees for your client.

2. If Seeking Investment, Choose a Corporation

There are more intricacies involved in investing in an LLC than a corporation, so choosing to only invest in corporations is very common in the investment community. LLCs sell membership interest in their company, which means interest is sold as a portion of the whole. See Cal. Corp. Code § 17703.04. For example, if there are currently two founders each with a 50% share of the company, one or both will have to give up a portion of their share in order to allot a certain amount to a third person, an investor. The new investor owns a piece of the company and will receive a K-1 statement each year indicating her share of the profits and losses from the company. She will file the K-1 on her personal income tax return annually, and will have to pay taxes on any profits from the business, even if the business decides not to issue profit shares to its owners (i.e. reinvest those profits in the business). Many investors choose not to invest in LLCs because of the paperwork and taxing scheme.

Alternatively, a new corporation is granted a certain number of shares when it incorporates. See Cal. Corp. Code § 200.5. The founders must choose how many to keep for themselves, how many to sell off to investors, and how many to divvy up to new employees. When a corporation sells a share of stock to an investor, the company gets the money that the investor put in and the investor gets to hang on to the stock (with her fingers crossed that the company will succeed and the value of the stock will increase). The investor will pay tax on her shares of stock upon sale (called a capital gains tax) or if the company pays out a dividend to its shareholders. Many investors prefer the simplicity and passiveness of owning stock in a corporation and avoiding the tax complications that come with buying shares of an LLC.  Accordingly, most venture funds simply will not invest in LLCs.

3. For Simpler Personal Taxes, Choose an LLC

LLCs are taxed just once. As noted above, owners pay personal income tax on their allocated share of profits, calculated and paid via their personal income tax return. See 26 U.S.C.A. § 701. There are no business taxes to pay.

Corporations, however, are taxed twice. First, corporate business tax is paid on the business income. See 26 U.S.C.A. § 11. Then, when the remaining revenue is distributed as either wages to employees or dividends to shareholders, that money is taxed again on the personal tax return of the receiver. One advantage to the two-prong corporation tax, however, is the ability to leave profits with the company.  Money not distributed as wages or dividends is not taxed on personal income, and therefore avoids the second level of taxation. While this can be very advantageous, especially for a highly successful company, it can cause a lot of unnecessary confusion for a small company that intends to stay small.

4. For More Ownership Flexibility, Choose an LLC

LLC founding members can dictate many operational specifics, such as ownership interest and perpetuity of the company, in the company’s governing documents. Members of an LLC can be granted disproportionate shares in their equity and ownership by simply saying so in the Operating Agreement. See Cal. Corp. Code § 17701.01 It is very easy, for example, to give a member 80% ownership when their capital contribution is only 50%. This means that the member provided half of the business’s equity, and is now receiving 80% of its profits. Corporations do not have this flexibility with their shareholders – the ownership percentage is always proportionate to the equity contributed. See Cal. Corp. Code § 200.5.

Owners beware! An LLC might self-terminate if one member dies or leaves the business, even if the other members would like to keep the business going, unless the LLC specifically chooses perpetuity. See Cal. Corp. Code § 17701.01  Declaring perpetuity in the Articles of Organization and the Operating Agreement, and specifically indicating that the LLC will not automatically dissolve upon the dissociation of any one member, can easily adjust this default rule. See Cal. Corp. Code § 17705.02. 

5. To Protect Your Personal Assets, Choose Either

LLCs and corporations will both protect your personal assets from your business’s debts and liabilities. A passive investor’s liability to repay the business’s obligations is limited to what you have invested in the company, never more. Therefore, (assuming no “piercing of the corporate veil”), a passive investor’s personal assets are protected from any failure or liability obtained on behalf of your LLC or corporation, so in either case you do not need to worry about company debts taking a bite out of your client’s personal life.

This article is for information purposes and does not contain or convey legal advice. The information herein should not be relied upon in regard to any particular facts or circumstances without first consulting with a lawyer.