A Start-up Businesses Guide to Choosing the Right Form of Entity (S-Corp, LLC or Sole-Proprietor)
If you are starting a new business and trying to determine which form of entity to create, we can help you make the right choice. It is impossible to make an informed decision without understanding the basic characteristics of the various kinds of business organizations established and recognized by state and Federal laws.
The ability of your business to raise and solicit funds, avoid unnecessary taxation, and generally operate in an efficient and manageable fashion depends upon what form of entity you choose to organize. Our attorneys will be glad to discuss various options and provide guidance to help you select and form an entity that will complement your business plan and strategy.
A “sole proprietorship” exists when an individual goes into business for him or herself, and it is the easiest way for an individual to operate an enterprise with a profit motive. There are no State or Federal filing requirements to establish a sole proprietorship, although operators of sole proprietorships must still comply with state and local license, permits, fictitious name filings, property tax and other requirements and regulations. A sole proprietorship is not a separate and distinct legal entity from its owner, and in the event the individual owner wishes to allow other owners to participate in the enterprise, the business must convert to a legally recognized entity such as a Corporation or Limited Liability Company.
For many businesses, the benefits from the ease of forming and operating a sole proprietorship may be outweighed by the risks inherent in this form of enterprise. Sole proprietors are personally liable for (i) claims and lawsuits made or filed against the business, and (ii) the debts, liabilities and obligations of the business. Thus, if an employee of a sole proprietorship hits a pedestrian with a vehicle while making a delivery for the business, the owner of the business has personal liability and risk exposure for any claims filed by the pedestrian in connection with the accident. Similarly, if the business defaults on a contract or cannot pay the expenses of the enterprise, the sole proprietor’s personal assets (house, bank accounts, etc.) may be used to satisfy the obligations and liabilities of the sole proprietorship under such circumstances.
Additionally, there may be tax advantages to reorganizing a sole proprietorship. Sole proprietors report their profits and losses on IRS Schedule C when they file their individual federal tax returns, with profits taxed at the owners’ individual income tax rates. While paying taxes via a Schedule C may be relatively easy, sole proprietors remain subject to the full amount of self-employment taxes (Medicare and Social Security Taxes). The self-employment tax rate for 2006 is 15.3% on self-employment income up to $94,200, meaning that sole proprietors must pay to the Federal Government $14,412.60 of such income in addition to income tax. If your net earnings exceed $94,200, you continue to pay only the Medicare portion of the Social Security tax, which is 2.9%, on the rest of your earnings over that amount. There may be significant savings with respect to these self-employment taxes to be enjoyed by a sole proprietor who reorganizes under a legally distinct entity.
Depending on the nature of the business and the revenue generated by the enterprise, a sole proprietor may find it advantageous to form a legally distinct entity under which to operate. In particular, there are no adverse consequences to converting a sole proprietorship to a Single Member Limited Liability Company. Our firm provides affordable and efficient solutions for reorganizing your business, and we will be glad to discuss with you the conversion of your sole proprietorship into an entity that affords personal risk protection and minimizes income tax exposure.
A General Partnership is technically formed whenever two or more people operate a business together and share in the profits and losses. However, most States (including Virginia) provide for general partnerships to formally file a Certificate of Partnership (or its equivalent) with the appropriate State filing agency, and these States formally recognize the partnership as a going concern with authority to transact business within the borders of the State. Any partner can unilaterally bind the partnership to any contract or other obligation within the reasonable realm of the partnership’s business activities. Further, each partner is personally liable for all of the business expenses, debts and other obligations, as well as the civil claims and lawsuits filed against the enterprise, to the extent that the partnership is unable to satisfy such liabilities. The liability exposure of a partner is not proportional to his or her respective ownership interest in the partnership, and creditors are not required to abide by any internal agreements made by the partners regarding satisfaction of the liabilities and obligations.
The ability of a partner to unilaterally bind the other partners, together with the personal risk exposure for each general partner, has made the general partnership form of business fall out of favor in recent years, particularly in light of the considerable protection and flexibility offered by the limited liability company.
A Limited Partnership is an organization that is used primarily to raise money from passive investors, who become the “limited partners” of the enterprise. Limited partners do not participate in the management or operations of the limited partnership, and they are not responsible for the debts or civil claims of the limited partnership above any beyond their investment in the business. Every limited partnership must have at least one “general partner” who manages the day-to-day operations and affairs of the partnership. However, each general partner in a limited partnership is personally liable for all of the debts and obligations of the business, including any civil judgments obtained against the partnership. A limited partner who materially participates in the operations of a limited partnership may inadvertently find him or herself deemed a “general partner” for liability purposes. A general partner in a limited partnership has significant risk exposure with respect to the affairs of the enterprise, but our attorneys can work with you to minimize the risk exposure of the principals who intend to act as general partner. Limited partnerships are formed by filing a Certificate of Limited Partnership (or its equivalent) with the appropriate State filing agency. Compliance with State filing and organizational laws is essential to ensure that your limited partnership is validly formed and offers true liability protection for its limited partners.
General partnerships must have at least two participants and may have an unlimited number of partners. Limited partnerships must have at least one general partner and may have any number of limited partners. Either partnership variety should operate and govern itself according to the terms of a well planned and comprehensive written Partnership Agreement. Without a Partnership Agreement, the “default” provisions under the applicable State’s partnership laws apply to govern the affairs and operations of any limited or general partnership, and these default rules may not be in the best interests of the participants. Our attorneys have significant expertise in drafting and negotiating Partnership Agreements, and we can work with the principals of a partnership to ensure that their needs are adequately served by the Partnership Agreement.
Although partnerships are required to file annual tax returns, they do not pay federal income taxes because the profits and losses of the business pass through to the individual partners. Profits and losses in a partnership may be allocated unequally among partners, without regard to proportionate ownership interests, so as to take advantage of tax benefits. Although partnership accounting rules and regulations promulgated by the IRS provides significant flexibility for partners, partnership accounting is complicated and generally requires the involvement of a qualified accountant. Under certain circumstances, partnership accounting rules may not be in the best interest of the partners. In such instances, the partnership may wish to make as affirmative election to be taxed as an incorporated entity. We can work with you to determine whether your partnership would benefit from an alternative tax election.
LIMITED LIABILITY COMPANIES
The Limited Liability Company (LLC) is a relatively new business entity that has gained tremendous popularity in recent years because it overcomes certain limitations and restrictions inherent in other entity forms. LLCs provide owners (called “members”) the legal protection of limited personal liability for the business debts and lawsuit judgments of the company to the same extent as a Corporation. LLCs can have any number of members, and the members do not have to be residents of the state in which the company is formed. Unlike an S-Corporation, other business entities such as a corporation or another LLC can be members of a limited liability company, which affords its principals the ability to establish holding companies and subsidiary entities, and which can protect the identities of the owners.
Management. Many LLCs are managed by all of the members, but state law also provides for management of an LLC by one or more specially appointed “managers”. A manager may be a member of the LLC, or the manager can be an outside third party individual or entity that owns no equity in the company. In an LLC, the “manager” position generally encompasses and combines the traditional roles of officers (President, Treasurer, Secretary, etc.) and directors which are required in a Corporation. However, members of an LLC are free to appoint individuals to serve in one or more traditional officer positions, such as President or CEO, rather than utilizing the standard “manager” role. Either way, the company’s organizational and governing documents just need to be consistent and provide for and document the authority of a manager, CEO or other officer to act for and on behalf of the LLC.
LLC Taxation Basics
LLCs that have several owners are “Multi-Member” LLCs and are generally taxed by the IRS like partnerships, meaning that the LLC files an information tax return but does not actually pay taxes itself. Rather, the LLC passes its profits and losses through to its members, who report their portion of the LLC’s business income or loss on Schedule C of their individual income tax returns. An LLC that has one owner is called a “Single Member” limited liability company and is treated (by default) as a disregarded entity for Federal income tax purposes, just like a sole proprietorship. Thus, the profits and losses of the Single Member LLC aren’t taxed at the entity level and simply pass through to the single member, who then pays taxes on the income on his or her tax return. This means that both Single Member and Multi-Member LLCs offer the benefits of pass-through taxation of profits and losses and limited liability and personal protection for the owners. It is easy to see why the LLC of business organization has become the entity of choice for many new business owners.
However, both Single Member and Multi-Member LLCs can elect to be taxed as a Corporation. Importantly, certain qualifying Single Member and Multi-Member LLCs can elect to be taxed as an S-Corporation, which may provide an opportunity for the members to enjoy significant tax savings. Tax treatment and related implications are extremely important to consider when determining whether an LLC is the appropriate entity for your business. There are many factors to consider when determining whether the default IRS treatment is best for your company, or whether you should affirmatively elect to be taxed as an S-Corporation. We will be glad to discuss with you the pros and cons of each type of treatment, and help you make a decision that will best compliment your business strategy, plans and goals.
Forming and Operating an LLC
Charter document. Like other entities, limited liability companies are created in accordance with the applicable laws of the state in which the LLC is to be formed. Most state laws governing the creation of LLCs are similar, but certain procedures, forms, maintenance requirements and expenses vary from state to state. Generally, you must file a charter document (usually called “Articles of Organization”) with the appropriate filing agency in your state, and pay the required filing fees. The fees for filing the Articles typically average around $100, but vary slightly from state to state. The requirements of what information must or may be set forth in the Articles of Organization vary from state to state, and it is critical that you meet your state’s requirements so as to avoid having your filing rejected. One very common reason for rejection of an LLC filing is the unavailability of the proposed name for the company in the relevant jurisdiction, where another entity has or had the same (or a similar) name. Because of this risk, our attorneys routinely verify the availability of the proposed entity name for our clients prior to filing the Articles.
Timing; Expedited Filing. Once a filing is submitted to the state, it can take anywhere from five (5) days to four (4) weeks (or longer) until the filing is accepted and the entity formed, so keep such delay in mind if time is of the essence for your business. Once accepted, the state’s corporate filing agency sends a Certificate of Formation (or similar counterpart document) which formally evidences the date that the filing of the company’s Articles was accepted by the state. However, the formation of the company is not complete at this point, and additional steps must be taken (see below). Many states offer expedited filing of the LLC charter document for an additional filing fee, which owners may find attractive if they need to form the company prior to a specific, short-term deadline. We have assisted clients form an LLC in just a few short days on many occasions, such as where an attractive real estate investment opportunity suddenly arises and the purchasers need to close immediately, but wish to take title to the property through an LLC for liability and tax reasons. Unfortunately, many of our clients enter into purchase agreements and other contracts in the name of their LLC before it is actually created by the state, and such contracts are generally unenforceable since the LLC didn’t exist at the time of the contract. As you can see, the expedited formation of a limited liability company may be a critical issue for many business owners, and our attorneys will be glad to accommodate your timing needs when assisting with the filing of your LLC or other entity.
Requirements After Filing. The laws governing limited liability companies in almost every state set forth certain corporate actions that must be taken in order to accomplish what is known as “completing the organization” of the LLC. These actions may vary from state to state but generally include (i) assignment of rights by the organizer to the members or managers, (ii) preparation and formal adoption of an Operating Agreement, (iii) issuance of equity to the members, and (iv) appointment or election of officers or managers, and acceptance of such appointments. These actions are most easily accomplished and evidenced by written consents, and it is a good idea to include certain other fundamental organizational decisions in these documents, which should be filed with the company’s corporate records book. Only after these final organizational steps are completed is the company considered a validly formed entity with a separate and distinct entity from its members. Many business owners who create an LLC by themselves omit these final critical steps, which subjects them to significant personal risk in the event their business is sued. If the party filing the lawsuit discovers that the members of the LLC did not comply with the minimum state law organizational requirements, the party can ask the court to disregard the LLC’s separate legal status and hold its owners personally liable for the business debts or other claims brought against the company (called “piercing the LLC veil”). In our litigious society, it is of paramount importance that business owners validly complete the organization of their company, in full compliance with state and local laws, in order to create and maintain a corporate shield against personal liability.
After completing the organization of the LLC, its members (or managers) must obtain an EIN, make any special desired tax election, and open a business banking account. Additionally, the company should obtain necessary local permits, licenses or other clearances for its operation, and file any fictitious names under which it intends to trade or transact business. From this point on, the members must respect the status of their LLC as an entity separate from the members, which means among other things that (i) all business expenses should be paid from the company’s bank account (rather than by the owners), (ii) separate accounting records should be kept for the company, (iii) annual meeting minutes should be prepared on an on-going basis and placed in the company’s corporate records book, and (iv) special written consents should be prepared and placed in the corporate records book to evidence due consideration and voting for all important business decisions. Due to client demand, DGW established a Corporate Minute Book Program to our business clients who prefer to simply focus on operating their businesses rather than satisfying the on-going state law corporate compliance requirements. We prepare the annual meeting minutes, any needed special written consents, and act as Registered Agent for enrollees in the Program on a year-to-year basis.
Operating Agreement. Many states require that an LLC adopt an agreement called an “Operating Agreement”, which is similar to a Partnership Agreement, and effectively acts as the combined counterpart to the Bylaws and Shareholder Agreement for a corporation. Essentially, the Operating Agreement sets forth the internal rules for governing the LLC, including the respective rights, obligations, and duties of the members. Although many Internet entity formation companies would disagree, there is simply no such thing as a “one size fits all” Operating Agreement form that will work for all LLCs, as the nature, goals and business plan of every LLC differs, as do the needs and wants of its individual members. It is important that an Operating Agreement be carefully crafted to accommodate the needs of the company and its members, and a well-drafted Operating Agreement should clearly and thoroughly address the following topics:
• Who will manage the day-to-day operations of the LLC, and what liability such managing parties have;
• Limitations on the authority of the managers or officers to bind the company or to unilaterally take extraordinary actions or consummate significant transactions;
• Indemnification of members and managers (or officers)
• Election and removal of officers or managers;
• How the LLC will be taxed for IRS purposes;
• Transfer restrictions (ie. restricting the sale of a member’s ownership interest to a third party without providing for a right of first refusal), and an exit strategy for the members including the calculation of the value of the ownership interests of the members upon any buy-out;
• Drag-along or tag-along rights, in the event all or substantially all of the equity in the LLC is purchased by a third party
• Admission of new members upon the vote of the current members;
• Allocation of profits and losses, and the timing and amount of distributions of cash flow;
• Whether members will be required to invest additional capital after their initial contributions, and the penalties for a member’s failure to contribute when so required;
• Whether any members will be entitled to guaranteed payments for services rendered, or will be otherwise employed by the LLC in any capacity;
• The ability of a member to transfer all or a portion of the member’s ownership interest to another member, or to a trust or other entity for estate planning and business succession purposes;
• How the capital accounts of each member will be maintained or adjusted throughout the life of the business;
• Any voting or distribution rights, preferences or restrictions inherent in the equity issued to various members (ie. different classes of equity);
In the event the Operating Agreement fails to address the foregoing, as well as other important ground rules for running the LLC, the company and its members will be subject to the default laws of the state in which the LLC was formed. More often than not, these default laws are not in the best interests of the LLC and its members because they do not address the individual needs or goals of the company and its members. Even Single Member LLCs should adopt a written Operating Agreement, so as to further substantiate the separate and distinct identity of the company from its owner and prevent piercing the corporate veil.
Typically, Operating Agreements are extensively negotiated by partners at the inception of the company. As the enterprise enjoys success and creates wealth for the members, the importance of having a thoroughly prepared Operating Agreement becomes compounded. Far too often, companies come to us with no Operating Agreement, or a poorly drafted agreement that was modified from a form found on the Internet. We are happy to work with the members of an LLC to revise their Operating Agreement to meet their needs, and we also offer preparation of an Operating Agreement as part of our turn-key, full service LLC Entity Formation Services.
LLCs have both advantages and disadvantages relative to other entity forms. Feel free to contact our firm for a legal consultation, so that we may help you determine whether or not a limited liability company is the best choice of entity for your business.
The oldest and most prestigious form of legal entity is the Corporation, but like every other form of entity, there are both pros and cons to operating your business as a corporation. Like LLCs, Corporations limit the personal liability of the owners (called the “shareholders”) for the corporate debts, legal claims and other obligations of the business. Anyone can form a Corporation and incorporated businesses qualify for many corporate tax breaks unavailable to Partnerships, LLCs and Sole Proprietorships. However, Corporations are generally the most expensive entity form under which to operate and are subject to more complex tax rules, so only successful businesses will ultimately enjoy the potential tax advantages of incorporating. There are also more on-going corporate governance formalities that are required to be taken by Corporations, and all of these increased expenses of operation must be considered when selecting the form of entity for your business.
Management. Corporate law varies slightly by jurisdiction, but in most states, Corporations are required to have one or more Directors, and may have a President, Secretary, Treasurer and one or more Vice Presidents (called “officers”). The specific officer positions that any particular Corporation must have is generally determined by its Bylaws. The shareholders of the Corporation elect the Directors in accordance with the voting and election provisions set forth in its Bylaws (and possibly a Shareholder Agreement), and the Directors have the authority to exercise all corporate powers and manage the business and affairs of the Corporation, subject to limitations set forth in the Articles of Incorporation. The Directors (often called the Board of Directors) appoint the agents and officers of the Corporation, direct the business and govern the policy and plans of the Corporation. Directors generally owe a duty of care, loyalty, good faith and fair dealing to their Corporation, and can be held liable to the shareholder in the event they breach such duty. Often in corporations owned by a single shareholder, the sole shareholder serves as all of the officers and the Director.
Formation of Corporations. Like LLCs, Corporations must be established in accordance with the applicable laws of the jurisdiction in which the entity is to be formed. While state laws governing the formation of Corporations are very similar, certain procedures, forms, maintenance requirements and filing expenses vary from state to state. Generally, you must file a charter document (usually called “Articles of Incorporation”) with the division of corporations in your state, and pay the required filing fees. The fees for filing the Articles of Incorporation range from $50 to $1,000, depending on the jurisdiction in which you file. The requirements of the information which must be set forth in the Articles of Incorporation vary by jurisdiction, and failure to comply with your state’s requirements will result in your Articles being rejected. A common reason for rejection of a Corporation’s Articles of Incorporation is the unavailability of the proposed name for the entity in the relevant jurisdiction. Because of this risk, our attorneys routinely verify the availability of the proposed Corporation’s name prior to filing the Articles of Incorporation.
Timing; Expedited Filing. Once the Articles of Incorporation are submitted to the state, it can take anywhere from one (1) to five (5) weeks (or longer) until the Articles are accepted and the corporation is formed. Once the filing is accepted, the corporate filing agency for the relevant jurisdiction sends a Certificate of Formation (or similar counterpart document) which formally evidences the date of corporate existence. However, the formation of the corporation is not complete at this point, and additional steps must be taken (see below). Many states offer expedited corporate formations for an additional filing fee, which business owners may find attractive if they need to form their corporation immediately for some reason. Many of our corporate clients enter into contracts in the name of their pending Corporation before it is actually recognized by the state, and such contracts are generally unenforceable since the entity didn’t exist at the time of the contract. As you can see, the expedited formation of a Corporation may be a critical issue for many business owners, and our attorneys will be glad to accommodate your timing needs when assisting with the filing of your Corporation.
Requirements After Filing. Next, the principals must take certain steps to “complete the organization” of the Corporation. These actions slightly vary by jurisdiction, but generally include (i) the election of the initial Directors by the organizer, (ii) the assignment of all rights by the organizer to such Directors, (ii) preparation and formal adoption of Bylaws, (iii) issuance of shares to the owners of the Corporation, and (iv) appointment or election of officers, and acceptance of such appointments. These actions are most easily accomplished and evidenced by written consents, and it is a good idea to include certain other fundamental organizational decisions in these documents which should be filed with the corporation’s official records book. Only after these final organizational steps are completed will the company be considered a validly formed entity pursuant to applicable law, with a separate and distinct entity from its owners. Even Corporations with one owner should take these actions to show that the owner truly respects the legal existence of the business. Many business owners who file a Corporation by themselves omit these final steps, which subjects them to significant personal risk in the event the business is sued. If the party filing the lawsuit discovers that the principals of the Corporation did not comply with the minimum state law organizational requirements, the party can ask the court to disregard the Corporation’s separate legal status and “pierce the corporate veil” to hold its owners personally liable for the debts and other claims brought against the business. It is best to complete the organization of your Corporation immediately following its inception in order to minimize personal risk exposure.
After the organization of the Corporation is completed under applicable state law, its officers or Directors must obtain an EIN and open a business banking account. Additionally, the corporation should apply for required permits, licenses or other clearances for its operation required by state or local law, and file any fictitious names under which it intends to transact business. From this point on, the shareholders, officers and Directors must treat the status of the Corporation as a separate and distinct legal entity, which means among other things that (i) all business expenses should be paid from the corporation’s bank account, (ii) accounting records should be kept for the corporation, separate from the personal financial records maintained by the principals, (iii) annual meeting minutes must be prepared on an on-going basis and should be placed in the Corporation’s records book, and (iv) special written consents should be prepared and placed in the corporate records book to evidence due consideration and voting for all important business decisions. Even a one-owner Corporation should prepare these documents to demonstrate that the owner takes the legal existence of the business seriously, so as to prevent piercing the corporate veil. DGW offers a Corporate Minute Book Program to our business clients who prefer to simply focus on operating their businesses rather than meeting on-going state law corporate compliance requirements. We prepare the annual meeting minutes, any needed special written consents, and act as Registered Agent for enrollees in the Program on a year-to-year basis.
Bylaws. Every Corporation must adopt Bylaws, which must be consistent with the Articles of Incorporation and the corporate laws of the jurisdiction in which the Corporation is formed. Bylaws set forth the rules and procedures that govern the operation of your corporation, and its shareholders, officers and directors. Any provision for regulating and managing corporate affairs may appear in the Bylaws. Bylaws provide a useful reference for officers, Directors, and corporate counsel to consult for verification that their acts comply with the Articles of Incorporation and applicable state laws, rules and regulations. Bylaws also enable the Corporation to adopt governing rules that constitute permissible variances of the state’s corporate laws, and to add rules not otherwise covered by state law. Bylaw provisions often address the following issues, in addition to many other matters:
• The location and time for annual and special shareholder meetings, and the manner of giving notice of shareholder meetings;
• Quorum, voting and proxy requirements for shareholders, and provision for shareholder action by written consent without a meeting;
• Whether shareholders will be entitled to receive certificates to evidence their shares of capital stock, and the procedures for lost, stolen, or destroyed stock certificates and issuance of new stock certificates;
• The number of authorized Directors on the Board of Directors and their qualifications, and the manner for election, resignation, and removal of Directors;
• The time and place for regular and special meetings of Directors, including the manner of providing notice for such meetings, the quorum and voting requirements, and any compensation payable to the Directors for serving on the Board;
• Whether the Board of Directors may appoint sub-committees for the conduct of the Corporation’s business;
• The executive officers of the Corporation, and the procedures for election, qualification requirements, term of office, resignation, removal, and vacancies of such officers; grant powers to the officers; describe the duties of the officers; and compensation for serving as officers of the corporation;
• Indemnification of the Corporation’s Directors, Officers, and employees; and
• General matters such as the Corporation’s tax year, governing law and the severability of any Bylaw provision if specific Bylaw provision held invalid by a court of law.
Unlike the Articles, Bylaws are not public records and typically do not have to be filed with any governmental entity. Bylaws should be adopted by your Corporation’s Directors at the initial organizational meeting, unless adopted by unanimous written consent. Alternatively, Bylaws can be adopted by the Incorporator and then ratified at the first Board of Directors meeting.
Shareholder Agreements. In the case of a privately held Corporation, all shareholders should enter into a Shareholder Agreement (sometimes referred to as a Buy/Sell Agreement). A Shareholder Agreement functions as a “premarital agreement” for a business, and it is critically important for shareholders to execute one right at the inception of the business, before their respective stock rises in value. Many of the issues addressed in the Shareholder Agreement will include:
• Whether a shareholder can sell the shareholder’s stock to an outsider, and whether there is a right of first refusal vested in the other shareholders that may be exercised prior to the sale of stock to any third party;
• What happens to a shareholder’s equity upon the death, disability or incapacity of the shareholder;
• Prevention of attempts by a court of appropriate jurisdiction to transfer a shareholder’s stock to someone else in connection with a divorce or bankruptcy proceeding;
• A shareholder who has been active in the business terminates employment with the company, voluntarily or involuntarily;
• Other triggering events that may require a buy-out of a shareholder or otherwise force the shareholder to sell his or her shares;
• In the event of a buy-out of a shareholder’s stock by the Corporation or the other stockholders, how the value of the shares being purchased will be determined, and whether or not part of the purchase price will be paid pursuant to a promissory note; and
• Agreement to vote in favor of certain stockholders in an election of Directors or officers.
We routinely assist our clients in addressing the foregoing issues, and we draft the ground rules for dealing with these future events when we prepare Shareholder Agreements for our business clients. The existence of the Shareholder Agreement gives the owners of the Corporation relatively equal bargaining power and forces them to the table to deal with any disputes or controversies. Even if the terms of the Shareholder Agreement are changed by negotiation between the owners in connection with a dispute, the Agreement will have gone a long way toward keeping the parties out of court, which is an expensive and inefficient way to settle disputes.
Corporation Taxation Basics
“C” Corporations. When the Articles of Incorporation are filed and accepted by the state, the Corporation begins life as a “C” Corporation under the tax code. A “C” Corporation is subject to Federal and state corporate income tax rules and regulations that differ from those for sole proprietorships, LLCs, partnerships and “S” Corporations. Generally, before any net profits may be distributed to the shareholders, a “C” Corporation must pay Federal and state income tax on the profits at the applicable corporate rate (15%-35%). Then, each shareholder must also pay taxes on any profits that are distributed to them from the Corporation as dividends, at the individual tax rate of the shareholder (unless the shareholder has other qualified investment losses). This is known as double taxation, where business profits are taxed at both corporate and the individual shareholder levels—a situation many small businesses try to avoid.
Unlike other entities, Corporations deduct the salaries paid to owners as a business expense when computing its net taxable income. As a practical matter, almost all profits are paid out as tax-deductible salaries and fringe benefits, so most small “C” Corporations aren’t overly concerned with corporate tax rates. A “C” Corporation enjoys the most tax-favored fringe benefits of any entity form, such as retirement and medical plans. However, the primary drawback of such benefit plans is that they generally must be offered to all employees of the business, rather than just the owners. Another advantage of a “C” Corporation relative to other entities is that it may accumulate profits to fund future growth and expansion (“retained earnings”). Retained earnings are taxed to the Corporation at lower rates than if they had been distributed to shareholders (who would pay taxes on the profits at their individual tax rates).
“S” Corporations. The shareholders of a “C” Corporation can make an affirmative election with the IRS to be taxed as an “S” Corporation. This election must be made with the IRS no later than the 15th day of the third month after a Corporation’s tax year begins (March 15th for most businesses), unless you can demonstrate to the IRS good cause for a late filing. Like LLCs and partnerships, “S” Corporations pass profits through to their owners who pay taxes on the earnings at their personal income tax rates, eliminating double taxation on profits. Losses also pass through “S” Corporations and can be taken by shareholders on their individual returns, whereas the losses of a “C” Corporation remain in the Corporation. Since new businesses often lose money during their first few years of operation, many owners of start-up “S” Corporations appreciate the ability to claim business losses directly on their personal tax returns to offset other income. Although “S” Corporations are not directly taxed, they are still required to file annual informational tax returns (Form 1120-S). Shareholders are issued Form K-1s which reflect the amount of profits and losses attributable to each shareholder based upon their pro rata ownership interests.
Unlike “C” Corporations, “S” Corporations cannot retain earnings by leaving some profits in the business in exchange for having those earning taxed at a relatively lower rate. Instead, the profits of an “S” Corporation pass through to its shareholders whether or not taken out of the business, and the shareholders must pay taxes on those profits at their individual tax rates. However, there are creative ways for an owner to save money on self-employment and FICA taxes by implementing a policy of taking “S” Corporation profits as a reasonable mixture of dividends and salary.
Only certain Corporations qualify to elect Subchapter S status, and failure to comply with IRS technical rules can result in your Corporation being deemed ineligible to operate as an “S” Corporation. In some instances, the owners of an “S” Corporation can inadvertently cause an involuntary conversion of the entity to a “C” Corporation by failing to comply with applicable restrictions. We routinely address these eligibility restrictions with our commercial clients, to assist them whether an “S” Corporation is the best form of entity under which to operate their business. Call us for a consultation to discuss whether an “S” Corporation is appropriate for your business, or whether a “C” Corporation or an LLC might be a more advantageous option.
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.