Business Creation: Part 2
LAST week, we gave a glimpse into the importance of formally organizing a business. We noted that member relationships change and business operations encounter problems. Thus, having sound internal controls combined with state-recognized external liability protection affords every business the confidence to focus on growth. To see that again, click here.
As promised, this Part 2 will highlight the most common entity choices for business owners facing the formal organization decision and provide some helpful insight about what organizational criteria matter most. As you read, think about the mechanics of your own business, either existing or prospective, and get a sense for how it might look within each framework. Let’s dig in.
The LLC, or Limited Liability Company, is designed for ownership and management by a few individuals and for that arrangement to stay relatively static in the early stages of business. By virtue of their ownership, individuals are formally regarded as “members.” Members are afforded voting rights, generally entitled to profits, and difficult to remove from their positions of ownership. Most importantly for members, North Carolina law shields them from any personal liability behind operations of the business. Put another way, the most an individual member can lose is that amount he or she invests into the business itself.
Continuing with the discussion of members, each LLC can be designated as “member-managed” or “manager-managed.” What this really means is that the entity is flexible enough to recognize that individual members each bring something specific to the table. Perhaps a couple of members seek only to be investors and want to avoid any management of day-to-day operations. The LLC can be easily structured to appoint a member who manages the daily affairs of the business while those investor members gently guide long-term strategy. Perhaps members have equally important, yet divergent competencies (consider a member brewer with a chemistry background and a member owner with a management background). The LLC can be arranged to give control over various aspects of the business to certain members based on what is reflected in the operating agreement. The key takeaway here is that the LLC gets a business moving in the manner intuited by the forming owners when it was but an idea. No one has to incur obligations they either have no interest or confidence in.
Without getting into the tax code weeds, LLC’s are awesome for small business accounting. Unlike its c-corporation counterpart, LLC members are taxed only on what they are paid through the company. For startups, reinvestment of any limited cash flow in the early stages is often critical. If the members are not making money, but putting it back into the business, why should they be taxed on it? With the LLC, company income is not taxed and members can be assured that they will not be taxed until they’re ready — either to take profits or hire non-member employees.
As a final note here, when it comes to formalities, many clients find the casual nature of the LLC a very appealing aspect. Most other structures (c-corporations, s-corporations, closely-held corporations, non-profits) require observance of an entire menu of corporate formalities, from quarterly and annual meetings to financial auditing, voting, and board member training. The LLC allows the members to impose their own level of company formalities within the operating agreement. Aside from the filing of a required annual report, how the company functions is largely up to the members. Of course, we often advise companies to give themselves some sophisticated structure to grow into, as having aspirational internal controls can shorten the learning curve for new businesses. But the ability to opt into sophistication is nice.
S and C corporations are varieties formal business organizations that, again, accommodate businesses in various stages of size and development. The designations “S” and “C” refer to which tax code the corporation adheres.
S corporations are often the next logical step in development for companies originally organized as LLCs for two primary reasons. First, S corporations are taxed much the same as the LLC. There is no corporate tax on the income of the S corporation generally and shareholders report any earnings on their personal tax filings. Second, S corporations avow the state law external liability shield for their members and maintain less rigid corporate formalities. The bylaws can recognize a similar level of managerial flexibility seen in the LLC above. So why would a business convert to the S corporation? There are a number of reasons, but namely growth. Organizing as a corporation generally allows capital investments much more dynamically and effectively than issuing equity from the LLC framework. The limitation as applied to the S corporation is the type of investors the corporation may take on. Unlike its C corporation counterpart, the S corporation may only have a certain class of individuals (not companies) take equity ownership in the business. As such, the S corporation is an entity type designed for smaller companies entering a new phase of growth that have the revenue to support the entrance of a few more shareholders.
Finally, C corporations are what you commonly think of when you hear the term “corporation” generally — Apple, Google, Amazon, etc. In the discussion of LLCs, we referenced a host of corporate formalities. Apply those here. Corporations are the most scrutinized company type by far. There is good reason, too. C corporations attract a variety of investor types and often issue a ton of equity. This means that interests in the company, stock, are readily transferred from one owner to another and that oversight of those processes is an abject necessity. We do note the distinction between private and public C corporations, as the control mechanisms differ depending on the public’s interest in the company. The hallmark of the C corporation is what is known as double taxation. Indeed, C corporations are taxed at the corporate level (when profits are realized) and at the shareholder level (when shareholders realize their own profits). As with the other entity types discussed, C corporations confer on their officers, directors and shareholders the ever-important personal liability shield.
This overview should give a decent look at the sliding scale of flexibility, complexity, and formality from the LLC to the C corporation. For purposes of satisfying our colleagues over at the State Bar, please note that this post does not constitute formal legal advice or the formation of an attorney-client relationship. If you are considering organizing or converting your business, schedule a consultation on our website, or shoot us an email. We are happy to assist you in the process, or refer you to a wealth of online resources to help you do what you can on your own.
Until next week. Cheers!
Originally published at www.carolinacraftlegal.com.