Step 4: Forming a Legal Entity
Forming a legal entity for your business is a great idea. A properly structured legal entity can offer your business certain protections from liabilities and other matters. It is best to choose a legal entity early in the start-up process so that you don’t have to worry about it later and so that you can receive the benefits from the beginning.
In forming an entity, you can choose from a variety of structures: an S-corporation, a C-corporation, a limited liability company (“LLC”), a sole proprietorship, a limited partnership, or a general partnership. However, almost all businesses now use either the corporate or LLC form. In making this choice, you should consider a number of tax and non-tax issues. Without knowing more about the specific plans and goals, it is difficult to convey everything that you should consider, therefore, we strongly recommend that you consult the advice of a professional; either a qualified lawyer, CPA or both. It’s always good to talk with several different individuals to get different points of view and opinions. The following paragraphs are a general introduction to the different types of issues to consider with the various forms and are greatly oversimplified.
1. Limited Liability. Corporations and LLCs both have limited liability, which means that the owners are generally not personally responsible for the obligations and liabilities of the entity. The exceptions to this rule are the same for corporations and LLCs: Owners are personally liable (a) if they act as guarantor of the entity’s debt, (b) if there is alter ego liability (i.e., creditors pierce the corporate veil), or (c) if they order, authorize or participate in company wrongdoing. The primary difference is that LLCs usually do not require annual meetings and other corporate formalities, which eliminates one factor used to find alter ego liability.
2. Management and Control. The control structure is important externally (for predictability and ease of transacting business with third parties) and internally (to govern the relationship among the owners and management). Generally, corporations have a highly centralized management structure. The shareholders elect the board (oversight and strategic decision-making) and the board appoints the officers (day-to-day control). The shareholders themselves may or may not be involved in holding management roles. This formal corporate structure is time tested and easily accepted by third parties in most business transactions. On the other hand, an LLC has almost total flexibility in its control structure. An LLC may be member-managed, which basically means its members exercise direct control. Alternatively, an LLC may be manager-managed, which means that one or more managers exercise the control. If manager-managed, it can be very loosely structured or, less frequently, it can be structured just like a corporation with directors and officers. Since LLCs are relatively new, they are less predictable in the business and legal world, and third parties may not be as readily willing to accept certain LLC management actions.
3. Cost and Complexity. At the simplest level, which costs most depends on the circumstances. As a very general rule, corporations cost less in legal and accounting fees to initially organize, but cost more to maintain over time. This is because LLCs are more flexible in their applicable internal rules, which often results in more upfront analysis and preparation; whereas simple corporations are generally more predictable and consistent. The reason that simple LLCs generally cost less to maintain is because LLCs generally do not require formal shareholder and board meetings and minutes, and they do not require separate taxable entity tax returns. However, when corporations introduce voting restrictions, multiple classes of stock, etc., they can quickly become more complex than LLCs to form. Conversely, when new members are added to LLCs, the costs of amending or restating the Operating Agreement can be more than the annual corporate formality costs. In either case, buy sell agreements should be created and generally cost the same for both corporations and LLCs.
4. Default Rules. For both corporations and LLCs, state laws are set up to provide “defaults” if the Articles or other documents do not express certain rules. For example, unless specified otherwise in the Articles or written agreement (a) the voting and inspection rights of LLC members are legally presumed to be nontransferable without the majority consent of the other members; whereas (b) for corporations, all of the rights of ownership are presumed to be transferable and no consent of the other shareholders is required. Because corporations have been around longer, many businesspersons are familiar with the corporate default rules, whereas the default rules for LLCs may create some surprises. This is the reason most business attorneys create long LLC Operating Agreements – so that the default rules are largely covered in the contract and the members are not forced to refer to the applicable statutes to understand their rights and obligations.
5. Tax Issues. Tax issues are very complex and important, so each founder should consult with his own independent tax advisor. However, at the broadest level, there are four tax choices available – to be taxed as a partnership if there are at least two owners, a sole proprietorship if there is one owner, a C Corporation, or an S Corporation. Assuming qualification under the Subchapter S rules, (a) LLCs can elect to be taxed under any of these alternatives, and (b) corporations can elect to be taxed as either a C Corporation or an S Corporation. An entity can elect Subchapter S status only if there are less than 75 shareholders, the shareholders are individuals or certain trusts, the shareholders are U.S. citizens or resident aliens, and there is only one class of stock. Many operating businesses that select LLC status over corporate status do so for tax purposes because they cannot qualify as an S corporation.
6. Capital Contributions. If all of the founders are contributing cash, this is not an issue for you. Otherwise, you should be aware that an LLC is more flexible than a corporation on what can be legally contributed in exchange for the ownership interest. For an LLC, you can purchase membership interests in exchange for money, property, services rendered or a binding commitment to contribute any of these. However, corporate law generally prohibits the issuance of stock in exchange for a commitment to contribute property or services, and only permits the issuance for stock in exchange for a promissory note if the note is adequately secured (by collateral other than the stock) or if the note is issued by an employee in connection with a stock purchase or stock option plan.
There will definitely be other factors that are relevant to your particular situation, and nothing in this article is intended to address any specific legal inquiry or substitute for independent legal advice. Since each situation depends on its own unique circumstances, the bottom line is to have your particular business situation evaluated by professionals before you form the company, rather than relying on the advice of non-professionals.
Don’t let the formation of a legal entity intimidate you; just understand the differences and, with the assistance of your professional advisor, pick the right entity for you and your situation. After you are on the road to getting an entity set-up, it is time to start thinking about the look and feel of your business; and it’s time to start thinking about how to brand your company.