A Primer on Entity Formation
Why form a limited liability entity (Corporation or LLC)?
A limited liability entity (a corporation or an LLC) provides both financial benefits and protection from liability. Among the financial benefits is 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 entity, your personal assets will not be placed at risk because of the actions of your company, provided you maintain the company's assets and activities separate from your personal ones 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.
Forming a corporation or LLC also 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.
What is the difference between an LLC and a Corporation?
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.
Should my business be a Corporation or an LLC?
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 passthrough taxation (see below). This is especially true if you do not meet the S-corp election requirements (also see below). 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. There are also fairly complex differences on how franchise taxes are calculated for S-Corps and LLCs depending on the jurisdiction, revenue, and profit of the company, so you should consult with an attorney and/or accountant to see what fits your specific financial situation.
What is pass-through/flow-through taxation?
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 (see below) are pass-through entities. This differs from a C-Corporation (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.
What is an S-Corporation and what are its requirements?
S-Corporations are corporations that elect to be treated as pass-through entities by the IRS by filing an S-Corp election. In order to qualify for S-Corporation status a corporation needs to satisfy several conditions, including the following: 1) all shareholders must be residents of the United States; 2) the corporation may only have one class of shareholders and may not have more than 75 shareholders; and 3) the company’s shareholders must be any of the following: individuals, estates, certain trusts, certain partnerships, tax-exempt charitable organizations, and other S corporations (but only if the other S corporation is the sole shareholder). This means S-Corporations may not be owned by other C-Corporations, LLCs, or foreign residents. If any of the requirements are not met at any time, the corporation automatically loses its S-Corporation status and will be treated as a C-Corporation.
What are the tax benefits of making an S-Corporation Election?
Many small business owners incorporate their businesses not only for legal protection, but also to reduce owners’ payroll taxes through S-Corp tax election with the IRS. One advantage of an S-Corp over a sole proprietorship, partnership, or disregarded entity is that it gives business owners the ability to reduce their self employment taxes. Any small business owner who has not made an S-Corp election and uses Schedule C for their personal tax return for 2010 is subject to both employer and employee FICA and Medicare payroll taxes at 15.3% up to $106,800, 2.9% Medicare for Schedule C net income greater than $106,800, and California SDI for 1.1% up to 93,316. If the owner of an S-corporation pays himself/herself a “reasonable salary”, the rest of the net income is not subject to these payroll taxes.
Can an LLC get the tax benefits of an S-Corp Election?
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 multimember LLCs defaults to be taxes as partnership since they are considered “disregarded entities” unable to get the tax benefits of an S-corp election. However, if a single or multiple member LLC agreement meets the IRS criteria to be classified as an S-Corp (see above), and the S-corp election is filed and approved by the IRS, then for tax purposes (not legal purposes), the entity is treated like an S-Corporation.
Where should I form my entity?
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.
Rimon offers the following flat-fee packages:
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Full organizational package (including Charter, Board Consents, Bylaws/Operating Agreement, etc.):
$1200 plus state fees -
Operating Agreement or Bylaws:
$900
THIS IS ONLY A SIMPLE OUTLINE. WE STRONGLY RECOMMEND YOU SPEAK TO A LAWYER TO LEARN WHAT IS BEST FOR YOU.
For a free consultation, or to learn more about our entity formation services, please contact us:
Email: .(JavaScript must be enabled to view this email address) Telephone: 800.930.7271