Why Form an LLC or a Corporation?

We are often asked by business owners if they should organize as a Limited Liability Company (LLC) or a corporation.  Here are some of the considerations that we typically discuss with them:

1.         Liability Protection:  Both an LLC and corporation insulate the owners from the company’s debts and obligations provided that the formalities are followed.   This liability protection often is a chief reason to move beyond a sole proprietorship.  (I previously circulated a memo on avoiding personal liability.  Please contact me if you would like a copy.)

2.         Tax Treatment:  An LLC and an “S corporation” (a corporation that has elected to be taxed as a partnership) are both treated as pass-through entities for federal tax purposes.  That is, the tax occurs at the member or shareholder level, avoiding a double tax that would otherwise occur at the corporate level, such as for a “C corporation".  On the State level, Massachusetts imposes a minimum tax on S corporations as well as a separate tax if total receipts exceed a threshold (in 2012, $6 million or more).

(Keep in mind that tax law is complicated and the comments above are simply general guidance. Specific tax advice is needed for each business.) 

3.         Who Are the Owners:  An S corporation may have restrictions on the number and types of owners, whereas an LLC may provide more flexibility.  This may be a concern if there are corporate owners or many of them.

4.         Management and Control:  An LLC may be either manager-managed or member-managed, whereas an S corporation is governed by its board of directors as elected by the shareholders, with operations handled by the officers.  An LLC can provide flexibility insofar as a manager(s) can be delegated broad authority in the Operating Agreement to run day-to-day operations as well as take more significant actions, with members reserving control over certain significant decisions.

5.         The Business Plan:  A relatively straightforward, stand-alone business may use either form.  If various businesses are contemplated, each organized as its own entity, multiple tiers of LLCs or corporations may be used, and series LLCs may allow setting up multiple businesses within one LLC.  The consideration is to shelter each business from the liabilities of each other business.

6.         The Contributions and Rights of the Respective Owners:   Consideration is given to owners who may make different contributions (e.g., cash, services, property) or may be active participants or passive investors, or if distributions of cash are to be made on other than a pro rata basis. LLCs may allow different and flexible distributions of cash and corporations may allow for priority distributions through the use of preferred stock.

7.         Financing and Capital Structure:  If the financing will be relatively straightforward, either entity may work.  However, outside financing from angel or venture capital investors may dictate the choice of entity. 

8.         Employee Compensation:  Either entity may work for standard compensation plans.  Stock options may favor a corporate form, although an LLC can be structured to provide analogous interests. 

9.         Filing Fees:  The original and annual filing fees in Massachusetts are slightly lower for corporations than LLCs. 

These are just some of the considerations.  Please do not consider them “legal advice” because the specific details of each business should be discussed with experienced counsel.

Please contact me if you or a colleague has any questions regarding forming an LLC or corporation or other business matter.  Please forward or share this post or blog with a colleague if you would like.