Whether to Incorporate of Form a Limited Liability Company

In the life of many small businesses, the questions usually arise: Should I incorporate my business? Should I form a limited liability company (LLC)? What are the pros and cons? As a lawyer, clients often ask me these questions. Knowing the advantages and disadvantages can help a business owner make the best choice.

Many businesses benefit from forming a corporation or limited liability company. The decision usually turns on two factors: (1) limiting liability and (2) tax planning. A business may decide to incorporate or to form a limited liability company (L.L.C.) for these reasons.

First this article will address corporations. Incorporating a business properly limits the personal liability of the business owners. If there is a claim against the business — for example, if a customer is injured or if a customer/vendor claims the business didn’t fulfill its contract — the most the owners of a properly formed corporation can lose is their investment in the business. By comparison, owners of unincorporated businesses (sole proprietors and partners) can lose their personal assets (residence, car, personal savings, etc.) in addition to losing their investment in the business. Incorporating properly avoids that big risk.

To obtain the desired limit on personal liability, the corporation must be set up and maintained properly. If it isn’t, a judge will let a claimant “pierce the corporate veil” and still reach the owners’ personal assets. In order to find a proper corporation, a judge will require the following:

  1. Proper paperwork to set up the corporation, e.g., Articles, Bylaws, and Organizational Minutes. A lawyer can assure this is done properly.
  2. Proper ongoing paperwork, e.g., annual meeting minutes.
  3. Corporate funds kept separate from personal funds, and a paper trail to show when and why funds have gone from owner to business or from business to owner.
  4. Adequate “capitalization,” which requires some explanation.

Adequate capitalization means having enough resources between corporate assets and insurance to cover most claims that could reasonably be expected against the business. Good insurance coverage for the risks inherent in a particular type of business will go a long way to meeting a judge’s requirements for adequate capitalization. Some types of businesses are more likely to have large claims and therefore need more resources to be adequately capitalized than other types of businesses. The idea is that an owner cannot create a corporation that is a mere “shell” and still escape personal liability.

Tax planning is the other factor in deciding whether to incorporate. An accountant can compare tax rates with or without incorporating. An accountant can help a business owner decide whether he can reduce payroll taxes by taking some profits from the business as “dividends” rather than as salary; dividends are available to owners of corporations, but not to sole proprietors or partners. Many businesses have a tax savings when they incorporate. If the business will become a corporation, an accountant can advise owners whether they will be better off tax-wise being a “C” corporation or an “S” corporation. The difference is how the corporation is taxed. A C corporation pays its own taxes, whereas an S corporation passes profits and losses through to the tax returns of the individual owners (called “pass-through taxation”). Pass-through taxation can often save small business owners some tax expense.

A Limited Liability Company (or LLC for short) is another option for setting up a business. An LLC is a mixture of the rules and benefits of corporations and partnerships. It is like a corporation in that it allows owners (called “members” rather than “shareholders”) to limit their liability to the amount they have invested in the business, so that owners’ personal assets are not at risk. Like a Subchapter S corporation and like a partnership, an LLC can give the owners “pass-through” taxation, meaning that the businesses’ profits and losses are taxed at the owners’ personal rates rather than at a (usually) higher corporate tax rate. Since not everyone can meet the rules for qualifying as a Subchapter S corporation (e.g., limits on the number of shareholders, requirement that S corporation shareholders be U.S. citizens), an LLC will allow those business owners to end up with a similar type of business structure.

An LLC is like a partnership in that there is flexibility to divide profits between owners many different ways. For instance, equal owners in a corporation must divide profits equally, but equal owners in an LLC or partnership may agree to divide the profits so that some owners receive more or less than others, for example, where one owner has devoted more time to the business than another.

It is important that an LLC be set up properly. This involves filing Articles of Organization with the Secretary of State, and having an Operating Agreement that accurately reflects how the LLC will be managed.

Depending on the nature of your business, an accountant may be able to recommend whether an LLC or a corporation gives you tax advantages. That may be the deciding factor whether to form an LLC or a corporation. An LLC can be preferable in some circumstances for the following reasons: (1) A judgment creditor of a member can only access money that would be distributed to the member, and cannot take ownership of the member’s share (whereas a judgment creditor of a corporate shareholder can take the shareholder’s shares), (2) It is easier for an LLC to distribute profits some way other than ownership interest percentages (e.g., 50/50 owners who agree to a 60/40 division of profits for some reason), or (3) One cannot qualify as an S Corporation, but one desires pass-through taxation (e.g., if one owner is not an American citizen). Remember that corporations have existed for many decades, so there is certainty in the rules such as how corporations are taxed, and what rights owners have among themselves. LLCs have only been around since the 1990s. There are some unsettled issues about LLC taxation and about their owners’ responsibilities as to each other, which can be a disadvantage. That uncertainty may or may not outweigh the advantages of an LLC, depending on the other circumstances present.

Each business client’s needs are unique. Attorneys and accountants can help you decide which type of business organization is best for your business.

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