To Be or Not To Be… A Corporation… Or an LLC… Or maybe a partnership?
The type of legal entity to set up is an important decision for new businesses.
A long time ago, the choice of what business entity to form was pretty simple – you had two choices. You could create either a corporation or a partnership. Corporations provide the owners limited liability but have the disadvantage of double taxation and very strict formalities that have to be observed. Partnerships are less formal and get pass-thru taxation, but at least one partner has to accept unlimited liability. Then in 1977, the state of Wyoming invented a hybrid entity, called the limited liability company (or LLC) which combined the best aspects of both – limited liability, pass through taxation and fewer formalities. The LLC idea was slow to take off: other states only started to follow suit in 1990, but by 1997, all fifty states offered LLCs as a choice and since then, its popularity has soared.
Until recently, most startups were advised to form an LLC because they combine some of the advantages of corporations and partnerships while avoiding some of the disadvantages. But the 2018 tax law changed the corporate tax rate. Now, some business owners are reconsidering whether a corporation is the right legal entity for them.
But tax status and legal entity are not the same thing.
Tax is obviously very important, and before deciding what entity to form, a consultation with a CPA is critical (see why here). But tax is not the only factor that needs to be considered as part of the entity selection analysis. Other, legal, factors are also important. Here are some of the most important non-tax issues to keep in mind: Formalities. There are different legal formalities for establishing and maintaining different types of entities. And of course, there are costs associated with these entities, both in creating them and on an ongoing basis. First, certain documents have to be filed with the state as part of registering a legal entity. Then, all legal entities must file and pay a registration fee every year to stay current. But corporations have more formalities than the other legal entities. Corporations have an additional requirement that before being registered, a notice has to be published in a certain newspaper. They also have to deal with the most formalities on an ongoing basis, like having a board of directors, holding annual meetings and keeping track of meeting minutes and corporate resolutions. These formalities are required by law even if the corporation only has one shareholder. An LLC has fewer formality requirements than a corporation, but more than a partnership. The only way to avoid formalities altogether is not to form a legal entity at all, but that would come with the risk of unlimited liability. Which brings me to consideration number: Liability. For many business owners, liability is one of the most important reasons – if not the primary reason – to choose to form a legal entity in the first place. It’s a special perk that allows owners of a legal entity to shield their personal assets (like their house and investments) from the liabilities of the business. That is, if the company is sued or has debts, and there’s not enough business insurance or money in the business account to cover it, then the owners will not have to pay out of their own pocket. Owners of corporations and LLCs definitely get to enjoy this protection, but that’s not necessarily the case with partnerships. Usually, there has to be at least one general partner who does not get the limited liability protection. Some states, like Georgia, do offer certain partnership options that allow limited liability for all of the partners, but the problem is that not every state recognizes these types of partnerships – in fact, very few do. So, if the company will be operating in more than one state, a legal analysis should be done. Company Management. This is where LLCs offer the greatest advantage because there are many more legal restrictions on corporations and partnerships: both on how the company must be managed and on the rights of its owners. For example, in partnerships, there are general partners and limited partners. General partners have an equal right to manage the business, regardless of how much they’ve contributed, but the limited partners have no right to manage the business, they’re just silent investors. Compare that will LLCs: the owners (called members) have a lot more flexibility. They can decide on the rules: how they themselves will be governed and how the company will be managed. They can decide that all members will manage the LLC or that only certain members will, or they can even decide to delegate the management to non-members. They can also decide to allocate profits and losses in a way that best suits their needs, which may or may not be based on how much each member contributed. So, now do you see why the LLC is such a popular choice of legal entity? It gets liability protection, with less formalities than corporations and the most flexibility in how the company is managed and taxed. Still, before choosing a legal entity, it’s important to evaluate both tax and non-tax considerations. The final decision should be made after understanding all the facts and the specific goals of the business.
As a business attorney, I advise clients every day on business risks and potential legal consequences. If you have any questions, please contact me at tanya@osenskylaw.com or 404.369.5126.