The following article originally appeared in the June 2009 edition of The Myers Report newsletter published by the firm.

 

What Should Your Business Be?  Corporation or LLC?

By Jane M. Myers, Esq.

 

As business law attorneys, we are often asked to form business entities for clients.  A number of questions always come up.

Should I form a corporation or an LLC?

What’s the difference?

I don’t want to be responsible for the company’s debts.  Will one form of entity provide greater protection from personal liability over the other?

How long will it take to do this?

What’s it going to cost?

The forms of business organization that provide owners with the least personal liability protection are sole proprietorships and general partnerships.  Entities that provide the most personal liability protection are the corporation and the limited liability company (“LLC”).  Both the corporation and the LLC are treated as legal entities separate from their owners so that debts or obligations of these entities do not, as a general rule, affect the owners.

In New York, most closely-held businesses (i.e. businesses that aren’t traded on a stock exchange or formed to provide licensed professional services such as architecture, engineering, law or medicine) will be organized as either a corporation  (designated as either a “Corp.”, “Inc.”, or “Ltd.”) or an LLC.

As a general rule, both entities provide individual owners with protection from personal liability provided that the owners conduct business in accordance with the Business Corporation Law and LLC statutes and so long as they haven’t agreed to personally guarantee the business’ obligations. However, there are a host of pros and cons that should be considered before deciding what type of entity is the best fit for a particular business venture.

Most people have familiarity with how corporations work. For that reason, this issue of the Myers Report will focus on the LLC.

Questions clients most often ask when deciding whether to conduct business as an LLC or a corporation . . . and the answers to those questions are . . .

• Will one entity provide more protection from personal liability over the other?

Both the corporation and the LLC provide equal personal liability protection for the business owner.

• What are the costs in New York to form a corporation and an LLC?

The cost to form a corporation, exclusive of attorney fees, is  approximately $300, which includes filing fees payable to the New York State Department of State and the cost of a corporate record book, stock certificates and a corporate seal. The costs to form an LLC are  greater because in addition to the State filing fees and the cost of the record book (approximately $388, exclusive of attorney fees)  the LLC statutes require that a notice of the formation of the LLC be published in two newspapers, once a week for six successive weeks, in the county where the LLC will have its principal office.  The county clerk of that county selects the newspapers for publication. The newspapers set their publication fees which can add anywhere from $200 to more than $1,000 to the costs of forming the LLC.  The LLC statutes also require that the members of the LLC enter into an “Operating Agreement” which details how the company will be run and typically is prepared by an attorney.  After formation, the corporation and LLC are each required to file a biennial registration statement with the New York State Department of State.  The cost to file the registration is $9.00.  One further point . . . while upfront costs to form an LLC are more than for a corporation, the costs may equal out fairly quickly since there will be accounting fees for preparation of the corporate tax return each year; but an LLC does not file a separate tax return.

• Are there tax advantages that one entity has over the other?

One of the principal advantages of an LLC is the availability of “flow-through” taxation.  This means that the company’s income will be taxed only once because it “flows through” the LLC and is reported directly on the tax returns of the owners.  By contrast (and unless the corporation has elected to be taxed as an “S” corporation as discussed below), the income of a corporation is taxed twice – once as corporate income when it is received by the corporation, and again as shareholder income when profits are distributed to them.  There can be other important tax differences between LLC’s and corporations depending on the particular circumstances, so anyone forming a business entity should always consult with their accountant or tax advisor.

• Is an “S” corporation different from a general business corporation?

No – an “S” corporation is not another form of legal entity.  It is the same as a regular corporation except with regard to tax status.  The “S” simply indicates that the shareholders have decided to take advantage of a special tax status which permits “flow-through” taxation (as described above).  This special tax status is available only if the corporation satisfies a strict set of requirements.  The principal requirements are: there cannot be more than 100 shareholders, the shareholders must all be individuals (with certain very limited exceptions), all of the shareholders must be U.S. citizens or resident aliens and there cannot be more than one class of stock.  Corporations that do not qualify for or elect “S” corporation status are known as “C”  corporations for tax purposes.

• What are the restrictions on ownership and transferability of my interest in an LLC?

There are, for the most part, no restrictions on who may be an owner of an LLC.  The only major exceptions are with respect to: (1) PLLC’s (professional limited liability companies), which, as the name suggests, are formed for the purpose of providing professional services such as those of doctors, lawyers, architects or engineers and may only be owned by licensed members of the profession; and (2) LLC’s in which the owners have agreed among themselves to place restrictions on the ownership and/or transferability of an ownership interest (such agreements are described in greater detail below).

• How does an LLC function?

An LLC differs from a corporation in that there are no officers (President, Vice President, etc.) or board of directors who manage the affairs of the company.  Instead, management of an LLC is similar to that of a partnership – all of the owners of the LLC (known as the “members”) vote in order to make the decisions to run the business.  The members usually vote in proportion to their membership interests (for example, in an LLC owned 2/3 by one member and 1/3 by another, the first member would have 2 votes to the other member’s 1 vote).  Members may, however, agree to an alternative voting procedure.  If there are too many members to make voting on all matters practical, or if the members believe that it would be best for the company to be overseen by a smaller group of people (or even a single person), then the members may elect or appoint one or more “managers” to operate the business.  Often, each of the managers will have 1 equal vote with respect to business decisions, though here again the members are free to establish their own procedures.

• What kind of agreement should I have with my “business partners” and what issues should it cover?

As noted above, the law requires that an LLC have an Operating Agreement which covers the details of how the LLC will be run.  These include whether the company will be managed by its members or by specific managers and how the members and/or managers will vote; how much cash or other contributions the members will make to the company; whether the members will be required to make additional monetary contributions to the company and how profits and losses will be allocated among the members.  An Operating Agreement will typically include restrictions on the transferability of a member’s interest and terms for the buy‑out of a member’s interest.  Restrictions on transferability are extremely important; owners of a small business don’t want to suddenly find themselves in business with a stranger who has purchased the interest of one of the other owners or the spouse of a deceased owner.  Buy-out provisions which come into play when an owner retires, becomes disabled or dies are also important because they provide a departing owner (or his or her estate/family in the case of death) with the ability to convert their interest in the LLC into cash.

A checklist of key issues to be considered by LLC members when drafting an Operating Agreement may be found here.  An article covering restrictions on transferability and buy-out provisions for the members of LLC’s, as well as the owners of other closely-held business entities, may be found  here.

 

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Please note that this article is intended only as a general discussion of issues pertaining to the formation of a business entity and that it should not be taken as creating an attorney-client relationship or as legal advice with respect to any particular person, business or situation.  Circumstances and the applicable legal principles vary and you should consult with an attorney and/or other professionals regarding the facts of your particular situation.