Most people who begin a business choose either the corporate form of business or the LLC (limited liability company) form of business. Both forms of business provide protection for the owners against business liabilities and obligations, which is why those forms of business are the most popular. One of the fundamental choices for the budding businessperson, therefore, is whether to operate as a corporation or an LLC. Both forms of business can be a good choice, but there are some advantages and disadvantages for both forms of business.
It should go without saying that a person going into business should consult an accountant (a CPA) for tax and accounting advice and an attorney for legal advice. Part of the “due diligence” what should be done is examining the advantages and disadvantages of the different forms fo business in light of current and future plans for the business. In this article, we explore a few basic considerations.
While forming a business as a corporation or an LLC provides a shield to the owners against business liabilities, that shield is not impenetrable. In fact, there is a legal term known as “piercing the corporate veil” that refers to ignoring the corporate or LLC form of ownership to find personal liability in certain circumstances. It is not enough to form a business as a corporation or LLC; the formalities of doing business as a corporation or LLC must be maintained in order to avoid personal liability.
If the formalities are not observed, the entity will be treated as a sham, and the “corporate veil” will be “pierced”. You do not want that to happen. LLCs have an advantage over corporations in that respect. LLCs are easier to maintain and have fewer formalities that are required to be maintained.
We all have a vague idea of how big corporations operate, but many small business people do not appreciate that all corporations operate (or should operate) the same way. Corporations are governed by the Business Corporation Act. All corporations have shareholders (the owners), directors and officers. Those roles are defined in the Business Corporation Act and must be further defined in bylaws for the specific corporation.
Generally, shareholders have meetings and vote to appoint directors, and directors have meetings and appoint officers (usually President, Vice President, Secretary and Treasurer at a minimum). The directors have the responsibility for the general oversight of the corporation, while the officers are responsible for the day-to-day operations.
These respective roles are ingrained in “corporate America”, but the structure often does not translate well in practice for smaller corporations, especially one-shareholder or two-shareholder corporations. The Business Corporation Act allows for some informal maintenance of that structure by allowing the corporate decision-making to be made using shareholder actions and director actions (without actual meetings), but the structure must, nevertheless, be observed to protect the integrity of the corporate form of business.
The records of these actions should be maintained in a corporate record book. The corporate record book should have actual stock certificates in it that are filled out and signed in the names of the shareholders, identifying their respective shares. There should be bylaws. There should be shareholder minutes of meetings or shareholder actions, and there should be director minutes of meetings or director actions for every year of the corporation. The directors’ actions should also provide a paper trail for all of the significant decisions of the corporation. All of these records should be maintained in the “corporate record book”.
LLCs, on the other hand, are flexible and can be organized to look like a corporation, a partnership, or even more creative structures. LLCs should have an operating agreement, which is the equivalent of bylaws, but LLCs do not necessarily need other paperwork that must be maintained on a year-to-year basis. That is not to say that having membership certificates and actions of the members or managers and other documentation may not be useful; but those things are not required as they are with corporations to maintain the integrity of an LLC.
LLCs provide other flexibility that corporations do not. LLCs can operate like corporations with tiers of directors and officers or equivalent roles with different names, but LLCs can also be designed to operate more like partnerships or other creative structures.
The way an LLC must operate is not defined as it is with corporations. This can be an advantage, though it can also be a disadvantage in the sense that the slate is clean and requires some structure. Forms for corporate structures are familiar, relatively simple and uniform. Forms for LLCs are many, varied and quite complicated.
Most business owners operating under the corporate form of business make what is called an “S corporation election.” That fancy terminology simply means that the business owners have elected to be taxed like a partnership, rather than a corporation. This is known as “pass-through taxation”. Instead of tax at the corporate level and then tax at the personal level when compensation is paid out or distributions are taken, all of the tax from the corporate level flows down to the individual tax return. There is only one level of tax.
S corporations do not have the flexibility or C corporations or LLCs. There can only be one class of stock. Shareholders can only number 25. These and other limitations make S corporations a poor choice if the idea is to solicit investors with shares of ownership.
One area where corporations have the advantage over LLCs is in the payment of the initial franchise amount and annual fees that are paid to the Secretary of State. The fee for incorporating a corporation is $150. The annual fee for corporations is $100. The initial fee for the organization of an LLC, on the other hand, is $500. And the annual fee is $250. In this way, LLCs are more expensive to form and to maintain in terms of the fees that are paid to the State.
Corporations also have the advantage of familiarity. People tend to be much more familiar with the corporate concepts of shareholders, directors and officers. For this reason, perhaps, corporations are still the most popular form of business. Most of the corporate formality maintenance is done with paper in the form of written shareholder and director actions. Though this type of formality is not required with LLCs, it is not very cumbersome and is easily accomplished.
There are other considerations that should be discussed with an accountant in regard to taxation and accounting. The determination of what type of entity to use in the beginning is an important one. A business can change from the corporate form of ownership to the LLC form of ownership, and the other way around, but changing the form of ownership can have adverse tax consequences and, therefore, may be cost-prohibitive.
Understanding some of the differences and the advantages and disadvantages of the corporate and LLC forms of ownership will help a person make an informed decision from the beginning.Kevin G. Drendel Drendel & Jansons Law Group 111 Flinn Street Batavia, IL 60510 (630) 406-5440 www.batavialaw.com www.ilfamilylaw.com
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