NH Legal Perspectives -- Choosing a business entity: IncorporatedBy PAUL REULAND
May 27. 2018 12:32AM
Second of two parts
A startup business needs to choose the appropriate and most beneficial legal entity in which to operate. An appropriate entity can serve as a valuable foundation in helping a business achieve its goals. If chosen improperly, it can hinder a business's growth and expose its founders to unexpected personal liability.
This article highlights some of the important distinctions between the most commonly used incorporated business entities. Last week's article addressed unincorporated entities.
An incorporated business is a legally recognized entity that has rights, privileges and liabilities distinct from those of its members. As a result, the obligations of an incorporated business, absent corporate misconduct, remain those of the business and do not become those of its members.
To incorporate, a business must file articles of incorporation with the state in which it operates. Once the incorporation has been certified by the state, the business must be certain to adhere to its bylaws (hold annual meeting, keep meeting minutes, maintain accurate financial records and hold shareholder votes on certain corporation actions). Since incorporated businesses are generally more complex and face greater accounting and reporting requirements than unincorporated businesses, they typically face higher professional and administrative expenses. The most common types of corporations are the C corporation and the S corporation.
Most publicly traded companies in the U.S. are C corporations. C corporations have the ability to issues multiple classes of stock and, as a result, are excellent entities for businesses which anticipate the need to raise a significant amount of capital.
For example, a C corporation conducting multiple rounds of financing has the ability to offer several classes of preferred stock. This is highly appealing to venture capitalists as it allows them to protect their investment and gain some control over the direction of the business.
Additionally, C corporations are not restricted in the number of shares they can issue and their shareholders need not be U.S. citizens or residents. Thus, if a C corporation is publicly traded there will be an extremely large market for its shares.
From a tax perspective, C corporations present some advantages and disadvantages. An attractive feature of the C corporation is that it may, subject to certain restrictions, deduct the costs of employee benefit programs, such as health care, as a business expense. C corporations are, however, subject to what is referred to as "double taxation." The first level of taxation occurs when the corporation, as an entity, is taxed on its profits. The second level of taxation occurs when the corporation makes distributions to its shareholders, who must also pay tax on the money they receive.
Management responsibility for a C corporation rests with the board of directors and the officers. While the articles of incorporation appoint the first board of directors for a corporation, after their initial term expires, they are elected by the shareholders. The board is the locus of management authority and responsible for the direction of the corporation as a whole. To execute their vision, the board appoints officers who are responsible for the day-to-day operations of the corporation.
S corporations are creations of the Internal Revenue Code. A business wishing to receive S corporation status must elect, within a certain timeframe, to be taxed under Subchapter S, Chapter 1 of the IRS Code. S corporations may only issue one class of stock and must have under one-hundred shareholders, all of whom are U.S. citizens or residents (with exceptions for certain trusts, estates and charitable organizations).
The S corporation provides the liability protection associated with the incorporated form but allows for the tax benefits typically afforded to unincorporated businesses. Specifically, an S corporation is not a separate taxable entity for federal, and most state, income tax purposes. Instead, profits and losses of an S corporation are divided pro rata among the shareholders and "passed through" to their personal returns.
S corporations will have greater access to capital than unincorporated businesses but will be limited by the fact that it can only offer one class of stock. Experienced investors and venture capitalists want to protect their investment and gain a measure of influence over the operations of the business so they often require preferred shares.
Management of an S corporation conforms to the same management principles of a C corporation, as discussed above.
Limited liability company
The limited liability company (LLC) is a hybrid entity that combines the best aspects of a partnership and an incorporated business. Specifically, an LLC protects the owners from personal liability while allowing business profits and losses to be "passed through" to their personal returns.
While an LLC appears similar to an S corporation, an LLC may have an unlimited number of shareholders. In an LLC, shareholders are referred to as "members," and their rights and obligations are defined in an operating agreement. The operating agreement will also indicate whether the LLC is "member-managed" or "manager-managed." Member-managed LLCs grant management rights to all of their members, similar to a partnership. Most, but not all, smaller businesses choose this form. Larger businesses, or those with members that have limited management experience, may choose to operate as a manager-managed LLC where managerial authority will rest with specific members.
As previously mentioned, LLCs enjoy similar tax treatment to unincorporated businesses and S corporations as profits and losses "pass though" to the members in proportion to their ownership. However, LLCs doing business in New Hampshire may be subject to the Business Enterprise Tax and/or the Business Profits Tax if their economic activities reach a certain threshold.
LLC members are required to pay self-employment taxes, which are calculated as a percentage of profits. In contrast, self-employment taxes in an S corporation are calculated based on salary, not profit. A final aspect of LLCs to consider is the fact that the cost of providing employee benefits is not tax deductible as it would be with a C corporation.
LLCs can present some problems when members need to seek additional capital. Venture capitalists tend to be reluctant to invest in an LLC because altering a pre-existing operating agreement to protect their investment frequently takes significant effort. Professional investors would much rather deal with an S or C corporation formed in a familiar jurisdiction, such as Delaware. In anticipation of this, many LLCs are formed with the understanding or agreement that in the event venture financing becomes necessary to continue business operations, it will convert to an S or C corporation.
Numerous factors should be considered when choosing a business entity. All businesses will have unique needs and goals, and choosing the correct entity at the outset will allow those goals to be met with the fewest complications. An experienced business attorney can help a new business owner choose the right entity and maximize its chances for success.
Paul Reuland leads the Start-Up Team initiative for Sheehen Phinney Bass & Green. He can be reached at firstname.lastname@example.org.
NH Legal Perspective is a biweekly column sponsored by Sheehan Phinney Bass & Green PA. This column does not provide legal advice. We recommend that you consult an attorney for specific guidance on legal questions.