Our attorneys are often consulted by entrepreneurs about the right choice of business entity for their new business. The answer in almost every case is a limited liability company (LLC).
Usually, the choice of business entity for a start-up comes down to an LLC or a corporation. What many do not realize is that both an LLC and corporation can have the same tax advantages. One of the tax law’s best kept secrets is that an LLC can choose to be taxed an “S corporation.”
A traditional corporation—a “C corporation”—is taxed on its profits and then its shareholders are taxed on dividends, creating two levels of taxation. It has more options for raising capital, and is the best choice for a business that sees a public offering in its future. However, unlike an LLC, the corporate form has far stricter organizational and governance rules under state law. On the other hand, taxation as an S corporation is very popular because it allows for only one level of taxation instead of two. Additionally, an entity taxed as an S corporation can allow an owner-operator to reduce his or her overall payroll tax exposure through distributions.
A business owner who has no immediate plan to take a company public will want an entity structure that is flexible, does not make too many demands for formality and paperwork, protects personal assets from business litigation, and maximizes tax advantages. In Georgia and most other states, an LLC can accomplish all of these objectives.
Below are some reasons business owners should consider an LLC as their preferred entity.
Same liability protection. Protecting personal assets from litigation is paramount for entrepreneurs. The LLC offers the same protection as a corporation for the owner-operator of a business. This protection is why we never recommend general partnerships or sole proprietorships, since these structures offer no protection to the owner.
Less formality. Corporations are required to have regular board and shareholder meetings, adhere to more paperwork requirements and file an annual report with the Secretary of State’s office. An entrepreneur has plenty to do and may find themselves skirting these requirements, which is never a good idea.
Even so, as a matter of best practices, our firm advises LLCs to adopt formalities that mimic those of corporations. The discipline is good for the business, and investors or acquirers will be impressed. In the event of a lawsuit, failure to respect any formality can be used in efforts to pierce the corporate veil; that is, to hold individuals personally responsible for the LLC’s liabilities.
Avoid double taxation. With a C corporation, profits will first be taxed at the corporate level. Then the salary or dividends received from the corporation will be taxed a second time at the individual rate, as high as 39.6%, not including state income tax and the extra 3.8% Medicare tax.
An S corporation (whether in an LLC or corporate form) benefits from pass-through taxation, meaning profits are only taxed once as individual income. The entity itself is not taxed. This is much simpler; and in many cases, owners hold on to more of the profits.
Another advantage of an LLC taxed as an S corporation is the ability to reduce payroll taxes. When an owner-operator is paid a salary but also wants to take additional money out of the business, those distributions avoid Medicare taxes. An owner who paid himself a $250,000 salary and took an additional $250,000 as distributions could save as much as $7,500 in Medicare tax. This is another example of the LLC being the best of both worlds.
LLC owners write the rules. LLC organizers also have the option of adopting an operating agreement. This document allows organizers to write their own rules on voting and investment rights of members, procedures that must be followed for the sale or transfer of a member’s interest, and other contingencies. One caveat is that if an LLC has elected to be an S corporation it will become subject to the stringent ownership and single-class of stock rules imposed on S corporations under tax law.
First, the analysis of LLCs in this article is based on Georgia law. There may be differences from state to state, notably in the rights of creditors in that state to pursue assets of the LLC or its members. Also, this article assumes that an individual is forming an operating business; an LLC formed only to hold assets raises different considerations.
Secondly, if there are expectations of going public or being acquired by a public company in the near term, forming a corporation may be the better option. There may also be tax advantages unique to corporations; under certain circumstances, a tax-free merger or acquisition between corporate entities can be effected. However, if IPO or merger goals are further out, we most frequently recommend starting the business as an LLC and converting to a corporation in the future.
Thirdly, an S corporation (whether in an LLC or corporate form) has restrictions on number and type of investors. With certain limited exceptions, only U.S. individuals are allowed to own an S corporation. Only one class of stock is permitted, which means preferred shares cannot be offered to a silent investor. All shareholders or “members”—that is what LLC owners are called—have equal investment rights; but the governing legal documents can establish different voting and management rights between the owners.
As with all legal matters, details of each individual situation must be examined, and one should consult legal counsel before making a decision. But for most businesses, the LLC will provide all the advantages of incorporation and leave more time and resources available for focusing on building the company.
If you would like to discuss which business entity is right for you, contact us today.