Rimon Law Blog

Forming an LLC or a corporation is an important first step to achieving tax benefits and protection from liability.  In order to preserve these important benefits, however,  it is very important that your company is maintained properly. Otherwise, you run the risk that the separate nature of your company will be ignored by the IRS or a court of law.   While there is no substitution for the sound advice of experienced counsel, a few simple steps will help ensure that you reap the benefits of your LLC or corporation for as long as they exist. The minimum requirements for maintaining corporations and LLCs is that they must:  1) maintain adequate capitalization; 2) keep clean financial and legal records; and 3) be treated as separate and distinct from its owners.

Maintaining Adequate Capitalization

Maintaining adequate capitalization means that the company must be financially prepared to cover the risks it is taking.  If a company is a high-risk company that has high potential of being sued (for example, a hospital) then it is required to have enough money in its bank account to cover such an eventuality.  The existence of insurance is an important consideration, since a company that is insured can cover its capitalization requirement by having enough liquid assets to cover the insurance deductible if and when a claim is brought against it.

Keep Clean Financial and Legal Records

Keeping financial and legal records of a corporation or a limited liability company starts from the day it is formed.  The charter (Articles of Incorporation or Formation), the bylaws/operating agreement, and the organizational consents must be carefully drafted and understood by the owners, managers and directors of the company.  They must then be adequately signed and preserved in a corporate binder.  Then, for the entire lifespan of the company, the rules of these documents must be adhered to.  Such rules may include annual shareholder meetings with corresponding minutes and resolutions by the board of directors or shareholders whenever necessary.  As a rule of thumb, whenever the company makes an important decision, it is prudent to make sure it is authorized by the appropriate parties, and properly documented.

Further, corporations and LLCs are legally required to keep and maintain clean financial records of the business, monitoring every dollar that comes in and out.  These formalities are often ignored by smaller companies where the shareholder(s), manager(s) and the director(s) are often the same people.  However, it is crucial that these formalities be observed. Otherwise the IRS or a court of law might find the company to be a mere shell and ignore it at the precise moment you wish to rely upon its liability or tax protections.  This is why both an accountant and a lawyer are important to maintaining a corporation or an LLC.

Keep Your Company Separate from its Owners

If your company maintains clean financial and legal records, you have mostly accomplished the last requirement of keeping your company separate from its owners .  However, you must also take careful measure to ensure that the owners do not mix their funds with those of the company. The owners’ personal expenses and the company’s expenses must be kept separate and distinct.  Further, the owners, managers and directors of the company must sign all of the company’s legal documents as representatives of the company and not in their individual capacities (i.e. as president of the company and not just by the individual personally).  Similarly any personal legal documents should not bear the name of the company.  If there is any confusion as to how an agreement should be framed, consult an attorney to avoid unnecessary future liabilities.

An LLC can be treated as an S-Corporation for tax purposes if it makes an S-Corporation election as long as the entity meets the IRS criteria to be taxed as an S-Corp, files an S-Corp election and gets approved by the IRS to be taxed as an S-Corporation. Without an S-Corporation election, single member LLCs default to be taxed as sole proprietors and a multi-member LLCs defaults to be taxes as partnership since they are considered “disregarded entities”. However, if a single or multiple member LLC agreement meets the IRS criteria to be classified as a small business corporation, the S-corporation election is filed and gets approved by the IRS, then for tax purposes, not legal purposes the entity is an S Corp not a LLC.

In order to be classified as an S-Corporation, a company must: be domestic, have no more than 100 shareholders, have one class of stock, all shareholders must be individuals, decedents’ estates, bankruptcy estates, trusts or tax-exempt charitable organizations, or wholly owned by another S corporation, and all shareholders must be residents of the United States (as defined by the tax code not immigration laws). Shareholders of an S-Corporation can not be financial institutions that use a reserve method of accounting for bad debts, companies taxable as insurance companies, taxable mortgage pools, or domestic international sales corporations. So, if a business entity meets these criteria it can be considered an S corporation by the IRS and taxed as an S corporation as long as the S corporation election forms are properly filled-out and approved by the IRS. Many states including California automatically give business entities an S-corporations tax status if it was approved by the IRS.

Whenever a corporation or limited liability company does business (i.e. enters contracts or agreements) in a state other than the state in which they are domiciled, they are required to do a foreign filing in that state. For example, if a business is incorporated in Delaware, but has an office and/or employees based in California, that business needs to do a foreign filing in California. In such a situation the corporation will need to pay franchise taxes in both Delaware and California.

This can be a very complex question. If you are looking to grow the company and get outside investment, then you should probably form an entity in Delaware. If your entity will have real estate holdings Nevada might also be a good option. Otherwise, it might make the most sense to simply form the entity in the state where you will be conducting most of your business.

In a pass-through (or flow-through) entity, the entity’s income and expenses “pass through” the entity and are treated as the income and expenses of its owners. LLCs and S-Corporations are pass-through entities. This differs from a C-Corpoartion (which is the default form of corporation) which is taxed a corporate income tax at the end of the fiscal year in addition to the personal income taxes and dividend taxes that its owners and employees pay. Federal corporate income tax is about 15% to 35% of profits, and most states also have corporate income tax. This means after a C-Corporation has paid its expenses for the year, it will be taxed at least 15%-35% of whatever is left above the amount the company started with that year. If the company is an LLC or an S-Corporation, there is no corporate tax, and indeed the owners can even apply losses of the company against their personal income.

If your business only has a few investors and you do not anticipate receiving outside financing in the near future, an LLC is probably best for you because of its flexibility, simplicity, and pass-through taxation (see blog entry on pass-through taxation). However, if you want a board of directors that is distinct from the officers and/or shareholders of the company, or if you are looking for institutional investors, then a corporation is probably a better form of entity because of its more organized and established structure of governance.

A corporation is made up of three groups of people – the shareholders, the board of directors and the officers, although the same person can hold multiple positions. The board of directors is formally elected by the shareholders and represents their interests. It is the board of directors that hires the officers of the company, also known as the management. The management’s job is to oversee the day-to-day operations of the company. Major decisions, however, require the approval of both the shareholders and the board of directors. A corporate structure is thus a highly organized and rigid structure of governance that can often be quite burdensome. A corporation requires a slew of corporate governance documents that must be frequently updated. It also requires that annual meetings be held for shareholders and the board of directors.

LLC stands for “limited liability company”. Generally it provides the same legal protections from personal liability as a corporation, however it is governed more like a partnership than a corporation. Whereas a corporation’s owners are called shareholders, the owners of an LLC are known as members. An LLC does not require a board of directors or even officers and can simply be managed directly by its members, if so desired. It can also be structured more like a corporation, with managers that are distinct from its owners. LLCs allow for significantly more flexibility than do corporations. For instance, the owners of an LLC can allocate distributions in whichever way they see fit. Even if the ownership of an LLC is split 60/40, the owners can decide to split the profits 50/50 – something that is not possible in a corporation without a significantly more complicated structure.

A limited liability entity (a corporation or an LLC) provides both financial and liability benefits. The financial benefits include the ability to deduct more business expenses from annual revenue when calculating taxable income than would be possible without an entity. Forming a limited liability entity also helps protect your personal assets in the event of a lawsuit or from debtors in a situation where your business’s liabilities exceed its assets. This means that as the owner of limited liability company, your personal assets will not be placed at risk because of the actions of your company, as long as the company is kept separate from your personal assets. This requires the corporation or LLC to: 1) make sure the company is adequately capitalized (it has the money necessary to cover the reasonably predictable legal and business responsibilities of the business); 2) that the company keeps clean accounting books and has accounts that are separate from the personal accounts of its owners or employees; and 3) that all legal documents are adequately maintained and the company complies with corporate governance laws.

Also, forming a corporation or llc usually makes it easier for a business to borrow money and to sell all or parts of the business in the future. It is important to note that the longer a business operates without a legal entity, the more complicated and expensive it becomes to transform it into one. For this reason it is very important to form a legal entity as soon as feasible.