Suppose you operated a company with two lines of business – a service business (e.g., six sigma consulting) and manufacturing (e.g., precision instruments or ball bearings). These businesses have different customers, growth prospects, financial statements, reinvestment needs, returns on capital, and cash flow characteristics. They face different types of risks.
In the 9th of his 14 points, W.E. Deming taught managers to break down barriers among staff areas. In the example above, the units are distinct divisions in a conglomerate. For organizational and practical purposes, good management would recognize that they should be kept separate.
In the event of a lawsuit, formal separation would prevent liability from spilling over into the other division. Management can determine which unit earns a higher rate of return on invested capital and which is the better choice for reinvestment. Perhaps, management will decide that one division should be spun off.
How can management achieve this artificial separation? Fortunately, good legal structuring techniques and corporate governance can handle this. While there are many forms that businesses can take, in most industries, the choice is usually between a corporation and a limited liability company (LLC). To make an informed choice, professionals require a basic understanding of the differences between the two types of entities.
This is the first in a series of articles that will discuss structural and governance issues including entity choices, formation, governance, compliance, and strategy.
Corporations have been part of American business for centuries. They are chartered under state law and owned by shareholders. LLCs have been around only since 1977. They tend to be more flexible and have fewer formalities than corporations do. The owners of LLCs are called members
Every entrepreneur has to choose the state in which to form the entity. While every state has its own specific laws, they are similar.
Limited Liability
Entrepreneurs form entities primarily to have limited liability. When people operate a business without an entity, they are sole proprietors. By forming a corporation or LLC and obeying the proper legal formalities, owners are relieved from personal responsibility for company debts and obligations.
Control
Corporations and LLCs differ with respect to how owners exercise control over their ownership interests. Corporate shareholders elect a board of directors, who hire management. In large corporations, shareholders tend to be uninvolved (i.e., passive) in managerial decisions. In small “closely held” corporations, the same individuals tend to be shareholders, directors, and managers. In LLCs, one or more members can manage the company, or they can choose an outside manager.
Transferability of Interests
Very large companies tend to be structured as corporations. The structure enables then to more easily raise capital and transfer ownership interests. Unless the shareholders voluntarily contract to not sell or transfer their shares, they can do so, albeit securities laws may apply.
With respect to LLCs, members can freely transfer the financial rights attributable to their shares. On the other hand, their rights to transfer managerial and voting rights are usually restricted. State law and operating agreements often require remaining members to consent for an assignee or purchaser to become a full member.
Continuity
Corporations and LLCs exist in perpetuity. They survive the bankruptcy, retirement, and deaths of their owners. Sole proprietorships die with the owner.
Taxation
Most entity choice decisions are driven largely by tax considerations. Thus, before choosing an entity, an entrepreneur or manager should consult with an accountant or tax professional who has experience with small businesses.
Regular corporations (C corporations) are separate legal entities. They file tax returns and pay taxes. Dividends paid to shareholders are taxed as well. This “double taxation” can be avoided if the corporation is eligible and elects to be taxed as an S corporation. An S corporation is a “pass-through entity.” It files informational returns with tax authorities but does not pay taxes. Rather, its shareholders report the profit or loss on their personal tax return. Some corporations are ineligible to be S corporations. Sometimes, it does not make practical sense to become one and deal with the legal restrictions.
LLCs, like S corporations and partnerships, are also pass-through entities. Where the member is an individual, he is taxed like a sole proprietor. Where the member is a corporate owner, the LLC is treated like a division of the parent company.
About the Author: Bryan L. Berson, Esq. is an attorney and mediator at The Berson Firm, P.C., a commercial and civil law firm that handles estate administration and planning, real estate, commercial transactions, mediation, and commercial litigation. His e-mail is bberson@bersonfirm.com. His phone number is (631) 517-1055. Connect with The Berson Firm on Facebook and Bryan L. Berson on LinkedIn. The firm’s website is www.bersonfirm.com.
Disclaimer: Constructive Knowledge is published by The Berson Firm, P.C. (the “Firm”). The information contained in this column is provided for informational purposes only. It is not tax or legal advice on any subject matter. No readers, clients or otherwise, should act or refrain from acting on the basis of any content without seeking appropriate legal or other professional advice with respect to one’s particular circumstances. This column reflects a general discussion of the law in New York. It may not accurately reflect the law of other states. The content is general information and may not reflect current legal developments, verdicts, or settlements. The Firm expressly disclaims all liability with respect to acts taken or not taken based on any or all content of this column. This column is Attorney Advertising. IRS Circular 230 Legend: Nothing in this column is intended to be used and cannot be used to avoid U.S. federal, state, or local taxes. It was not written to promote, market, or recommend any tax planning strategy or action. Copyright: All rights reserved. No part of this publication may be reproduced without prior written consent. Readers may share this column through, but not limited to, social networks.
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