LLC or Corporation? Does it really matter?
By: Julie C. Wiediger, Esq.
If you are about to embark on your first entrepreneurial endeavor, you are likely well aware of the need to protect your personal assets, and have likely decided to do so by forming a limited liability company or corporation. However, you may be confused as to which entity to choose for your purposes. This article explores limited liability companies (LLCs) and S corporations formed in Washington from the eye of a soon to be new business owner and provides information that may assist the new business owner in identifying their needs and selecting a path to formation.
You may be surprised to learn that there are no significant differences between the LLC and the traditional Corporation. In reality, there are differences, but with proper planning and drafting you can, in most circumstances, make either operate like the other. An experienced attorney can help you avoid pitfalls and draft the proper instruments to ensure that either your LLC or your corporation is serving the purposes that you desire.
Vision. If you have not done so already, you should take some time and get clear on your company’s vision. What would you love to see happen? How much room is there for growth? Do you envision yourself expanding out of state? Out of country? What should your organization look like? How do you want to manage your company? Who are your investors? Do you anticipate offering your employees stock options or LLC membership incentives? What about benefits and salaries? Getting clear on your vision will enable your attorney to guide you to the best entity or rather, will ensure that your operating agreement or bylaws reflect the vision, leave space for the growth that you anticipate, and give you the proper protections and ease in moving forward.
Formation. To form a LLC or corporation you must file either a certificate of formation (LLC) or articles of incorporation (corporation) with the Secretary of State and pay the associated $175 filing fee. A certificate of formation requires significantly less information than articles of incorporation. While incorporators can skip placing much of the information in the articles, the governance of the corporation will be subject to over 40 default provisions and it is important to understand their impact.
Formality versus Flexibility. The Washington Business Corporation Act, codified at Chapter 23B of the Revised Code of Washington, places demands on Corporations that do not apply to LLC’s and that may not be contracted away. For example, among other things, a corporation must draft initial bylaws, keep permanent records of all shareholders and board meetings, hold an annual meeting of the shareholders, maintain accounting records, and maintain certain records at its permanent place of business. Although there are certain formalities that must be followed, for the most part the Act permits Corporations to draft articles and bylaws that control the manner in which the corporation will act. LLC’s have significantly less default provisions, and very few requirements. These are found in the Limited Liability Act, codified at Chapter 25.15 of the Revised Code of Washington. LLCs should also draft an Operating Agreement that sets out the intentions of the Members and serves as a guide for moving forward in the future.
Management and Ownership. Owners of LLCs are members. LLC’s are generally managed by members. However, the LLC may elect to have a manager managed LLC, by which a member or other person is selected to manage the LLC. Owners of Corporations are shareholders. Every corporation must elect a board of directors who appoint officers to manage the company affairs. However, a sole shareholder or owner may fill multiple roles, and a corporation may dispense with or limit the authority of its board of directors if in its articles of incorporation if it identifies who will otherwise perform the duties of the board.
Taxation. One of the main perceived differences between LLCs and Corporations is taxation. In reality, a small business owner can choose either business entity and adapt their tax elections to suit their needs. A tax advisor should always be sought to address your specific circumstances and to obtain the best advice. However there are some basic tax principles with which you should be familiar.
The C-Corp/S-Corp Distinction. The main difference between a C corporation and S corporation is tax treatment. Regular-corporations, known as C corporations, are subject to a double taxation; i.e., tax imposed on corporate profits and again at the individual shareholder level on the dividends (distribution of profits). A corporation exists as a C corporation by default. In start-up situations C corporations are typically only used for companies that are looking for angel investors or venture capitalists. This is so because in these scenarios there are no double taxation issues. To be specific, where the capital requirements are high and there are no immediate expectations of profitability, there are no taxes and as such double taxation is not an issue. Venture capitalists also like corporations because unlike S corporations, in a C corporation you can have multiple classes of equity and it is easy to control the investment. For example, a C corporation may draft articles permitting “blank-check preferred stock” which allow a board of directors, without seeking shareholder approval, to define the specific designations or characteristics of a series of preferred stock.
S Corporation Election. Although a company must be eligible for S corporation election, a small business owner should rarely default as a C corporation and should elect to be treated as an S corporation and taxed as a pass through entity. This is true because an S corporation can avoid double taxation and generally is exempt from federal income tax other than tax on certain capital gains and passive income. As such, each shareholder includes their share of the Corporation’s profits and losses on their tax returns.
LLCs. An LLC by default, like a partnership or sole proprietorship, is not considered a separate entity from its owners for tax purposes. As such, an LLC generally does not pay any income tax, and instead the LLC members pay or deduct taxes on their allocated share of profits on their personal tax returns.[4] By default, a single member LLC will be disregarded for federal income tax purposes. Ultimately, an LLC is an incredibly flexible entity and may be classified for Federal income tax purposes as if it is a sole proprietorship, a partnership, or a corporation and your business needs should dictate your election.
Growing and Changing. Your company may grow and its needs may change. A new entity can always be formed and in most circumstances an existing entity can easily and affordably merge into a new entity. Or you can modify your election or articles to best fit within you needs. Although such changes may result in taxable events, guidance and planning on the front end can ensure that you are able to adequately grow and limit unnecessary future costs.
Conclusion
Either an LLC or a corporation can adequately protect your interests and can be modified to best fit your purposes. LLCs generally offer more flexibility and less red tape. Corporations have been around longer and are the appropriate choice for certain startups. As a business owner you must clearly identify your goals, be aware of the default treatment of your entity choice, properly elect taxation options, and draft your bylaws or operating agreement to be certain that your company is working for you.
