In the last blog, we discussed entity structure when starting a new business. This blog continues that discussion, weighing the pros and cons of a limited liability company (“LLC”) and a Sub-chapter S corporation (“S Corp”).
Why choose an LLC?
In Arizona, consider an LLC if your proposed venture is a single purpose business undertaking, such as the purchase of a building, development project, restaurant, or a retail establishment. Once the name of the company is cleared and reserved, formation can be accomplished by filing electronically with the ACC. In Arizona, forms to create and give birth to an LLC are on the Arizona Corporate Commission’s (“ACC”) website with a small filing fee. The owners of the LLC are members, and they own a membership interest in the LLC.T
The LLC is formed through a simple filing of Articles of Organization with the ACC, the designation of a statutory agent, and a description of the business of the LLC. The organizer must identify whether the LLC is member-managed or manager-managed. It is generally simpler to have a manager-managed LLC because other members are not needed to participate in transactions or formally sign documents and contracts. There is no further need to make any other annual report filings in Arizona.
A positive aspect of an LLC is that a membership interest may be owned by an individual, corporation, another LLC, or trust. This provides flexibility in creating the entity structure. As an additional benefit, a single-member LLC is not recognized by the Internal Revenue Service as a taxing entity, and all taxes are paid at the member level on the entrepreneur’s income tax return. This eliminates the administrative burden of filing a separate return for the company.
While Arizona does not require a written operating agreement, that document is strongly recommended. A detailed operating agreement should be prepared and signed shortly after the creation of the LLC. This important document sets forth the rights, powers and obligations of the manager and the members, and how the company is managed and controlled. The business formalities of a corporation, such as bylaws, minutes, and routine resolutions, are not required but some should be included in the operating agreement. The operating agreement is a broadly flexible document and should be carefully drafted after discussion with counsel and a CPA.
The LLC, however, is less flexible when adding new members. The ownership interest in the company must be restated, and the consent of all members is generally required. In that regard, an S Corp is more flexible because additional shares can be issued to prospective shareholders subject, however, to Federal and state securities laws. So, too, there is less flexibility with an LLC in dealing with capital infusions by existing or prospective new members. Capital accounts and allocation of the capital accounts must be carefully considered.
A Federal tax identification number is required for an LLC. By filing IRS form S-4, the LLC may elect to be taxed as a partnership, or it may elect to be taxed as an S-Corp for tax purposes by filing IRS Form 1065. The income earned by the LLC is taxable as profit and reflected on IRS Form K-1 and taxed directly to the individual member. Since most start-up companies incur losses in the first year or so of operation, this pass-through taxation aspect is one of the advantages of an LLC because the losses can be deducted on the member’s personal income tax return. The net profit of the LLC is not viewed as a member’s income and, therefore, it is not subject to self-employment tax but is paid as earned income as reflected on IRS Form K-1.
In short, the LLC is generally easier to create, has fewer administrative burdens, provides for flexible entity structure, affords liability protection and tax benefits to the individual members.
Why Choose An S Corp
The S-Corp is a corporation in the first instance where liability protection and tax advantages are available to the shareholders. The entity starts out as a regular corporation with a Federal tax identification number. The owners of the company are shareholders who may make an election to be taxed under Chapter 1 of the IRS Code, Sub -Chapter S provisions.
As with the LLC, the creation of the company is relatively simple and straight forward. The corporation is formed through a simple filing of Articles of Incorporation with the ACC with the designation of a Statutory Agent and a description of the nature of the business with a small filing fee.
With the S election by all shareholders, an S-Corp is taxed in much the same manner as a partnership with no company-level taxes (other than those states that charge a franchise fee regardless of the type of company formation). An S-Corp pays its employees a reasonable salary, while also deducting payroll expenses such as Federal taxes and FICA. After payment of the salaries, the remaining profits from the company, if any, can be distributed to the owners as dividends without the need for paying both the employer’s and employee’s portion of FICA.
The positive aspect of the S-Corp is that there is already a well-known and recognized business structure familiar to everyone in the business community. The S-Corp, like a C-Corporation, is managed by the board of directors who are elected by the shareholders. However, the day-to-day operations are managed by the officers of the company. Corporate law is well developed, and the rights, duties and obligations of shareholders, directors and officers are well defined. The corporation requires formal organizational minutes and regular corporate meetings with resolutions and corporate minutes. This structure provides for organized governance of the business. Annual filings have to be made with the ACC.
In general, the S-Corp is more flexible than an LLC in adding new shareholders and readily provides a vehicle for capital infusions from potential investors by issuance of additional shares, all of which are subject to federal and state securities laws.
In sum, if the business expects to grow and foresees the need for substantial capital infusion, the S-Corp is a more flexible vehicle. The formalities of an S-Corp give a potential investor confidence that the investor’s rights will be protected. If the entrepreneur anticipates significant growth in the future, the S-Corp may be your entity of choice. That decision should be made after reviewing the pros and cons with your CPA and business lawyer.
The next blog will discuss in more detail some of the mechanics associated with creating these business entities.
Lat J. Celmins
Disclaimer: This blog is for information purposes only. Legal advice is provided only through a formal, written attorney/client agreement.