In October’s inaugural Carlson Dash Digest, we began this three-part series with the purpose of helping you determine which entity will work best for the formation of your business by describing some of the requirements for formation, certain tax[1] and liability consequences, and some general pros and cons of each form. In October, we explored some of the benefits and detriments of forming and operating your business as a sole proprietorship. Last month, we discussed various partnerships. We conclude this month with a look at corporations, and a comparison of the advantages and disadvantages of the C Corp, the S Corp, and the Limited Liability Company.
If a partnership is not what you’re looking for, and a sole proprietorship will not work for your business, consider a Limited Liability Company (“LLC”), an S Corporation (“S Corp”) or a C Corporation (“C Corp”) instead.
A C Corp is a corporation that is taxed separately from its owners. Under Illinois law, a C Corp must follow all steps necessary to organize a corporation, such as: choosing at least one director; filing articles of incorporation with the Secretary of State; creating bylaws (and keeping a copy of the same at its principal place of business); filing an Annual Report with the Secretary of State at the end of each business year; and issuing stock certificates to initial owners of the corporation.
- Liability: Like any corporation, a C Corp is a separate legal entity from its shareholders, directors and officers, none of whom are ordinarily liable for the corporation’s obligations. Thus, a C Corp will generally protect its shareholders, directors and officers from contractual liability, and the potential losses are generally limited to the amount of the shareholders’ investment.
- Raising Capital: In addition, a C Corp can have an unlimited number of stockholders, thus allowing a C Corp to sell shares to a large number of investors, or have a stock sale if the company needs finances for expansion.
- Foreign Investors: Foreign nationals have a right to own or invest in a C Corp, allowing for a wider scope of investors. And the majority shareholder of a C Corp has the option of issuing different classes of stock to shareholders, to help attract a diverse group of investors.
- Tax treatment: A C Corp is taxed under Subchapter C of the Internal Revenue Code, which means that C Corps are subject to “double taxation.” The C Corp is taxed on its own income as earned, and then, if the corporation pays dividends to its shareholders, the shareholders are taxed individually on those dividends. If dividends are likely, investors will pay twice: once at the corporate level, and again at the personal level.
If you like the C Corp’s organizational structure, but dislike the way it is taxed, an S Corp may work. An S Corp has the same basic organizational structure as a C Corp, but is taxed like a partnership or LLC — meaning only one level of taxation instead of two. Instead, like a partnership or LLC, the corporation’s profits and losses “pass through” to shareholders.
How do you form an S Corp? The corporate entity is formed just as a C Corp, but then S Corp status must be designated with the IRS. The election for S Corp status is made by filing IRS Form 2553 no more than 2 months and 15 days after the beginning of the tax year in which the election is to take effect, or at any time during the tax year preceding the tax year in which the election is to take effect. But note: Illinois does not recognize “S” status in the same way that the IRS does, and does not require separate “S” election like certain other states, such as New York and New Jersey. Instead, Illinois imposes a “personal property replacement tax” on the corporate profits of an S Corp at a rate of 1.5%.
While there can be substantial tax advantages, there are limitations on S Corps.
- Diversity: An S Corp election may only be made if you have 100 or fewer shareholders. In addition, every shareholder must be a US citizen or US resident, with exceptions for certain trusts, estates and tax exempt organizations.
- Raising Capital: Given the above, the ability to raise capital may be somewhat more limited in an S Corp than a C Corp.
- Formalities: Certain formalities must be maintained regarding the income of the S Corp in order to keep your elected “S” status. Consult your advisor with regard to how these formalities may impact your S Corp election. Instead, like a partnership or LLC, the corporation’s profits and losses “pass through” to shareholders.
If you do not have an affinity for a corporation, perhaps an LLC is the most flexible choice. An LLC is a hybrid business organization that combines the best of corporations, partnerships, and sole proprietorships.
LLCs are flexible, allowing any entity (including individuals, partnerships, trusts, estates, corporations, or other LLCs) to be owners. Each owner of an LLC has limited contractual liability. Therefore, members of an LLC cannot be held liable for company losses, debts or business credit, unless otherwise obligated through a personal guaranty, for example. Though LLCs must have at least one member, LLCs do not limit the number of members.
Another advantage of LLCs is that they do not have to observe the formalities normally imposed upon corporations, such as producing annual meeting minutes, holding director meetings, or meeting shareholder requirements. However, an LLC must file Articles of Organization with the Secretary of State, must have an operating agreement, and must file Annual Reports with the state.
Profits and losses can be allocated differently than ownership or partnership interests in an LLC, and an LLC can have different classes of membership, which allows for flexible fundraising. While corporations must typically distribute profits in proportion to each of the shareholder’s ownership interests, LLC members may distribute profits in any manner they desire, without regard to each member’s capital contribution. However, an LLC will need sophisticated tax advice to comply with the Internal Revenue Code before such type of distribution, and distribution structures that are not proportional to members’ capital contributions should be set forth in the LLC’s operating agreement.
LLCs are taxed like general partners of a general partnership: the LLC does not pay taxes or take on losses. Instead, profits or losses are allocated to its individual members, and must be reported on members’ personal income tax returns.
Though it may sound like an LLC is the “golden child” of business entities, there are some disadvantages. LLCs cannot go public, as there are no shares or shareholders. Therefore, employee stock options are not a possibility. And even though the paperwork and other complexities associated with LLCs are significantly less than those required for forming a corporation, the formation of an LLC is still more complex than the formation of a partnership or sole-proprietorship.
Whether you choose any of the entities above to form your business, or happen upon another entity that suits you, you should choose the right attorneys to help make your business ideas a reality. The attorneys at Carlson Dash have the knowledge and experience to help you with every aspect of getting your business started, from helping you determine the best entity for your business, taking the necessary steps to form that entity, helping you navigate issues that inevitably occur as you start up, and further business and legal advice to help you sustain successful operations.
[1] The tax information provided herein is general in nature and not intended to be a substitute for advice from a provider of your choice with regard to your own personal tax situation.
This document is intended for informational purposes only and is not legal advice or a substitute for consultation with a licensed legal professional in a particular case or circumstance.
If you need assistance with a related matter, contact us.