July 28, 2014
By Lindsay A. Getman, Summer Associate
In part one of this series, we provided information on the benefits and disadvantages of sole proprietorships and partnerships as business entities. Part two of this series will discuss corporations and limited liability companies, two additional entity types that a business owner in New York may choose. These types of entity formations can be a costly and burdensome process for a business owner, but formalizing the business structure in this way can also provide numerous benefits and protections. In New York State, business owners may choose from the C corporation, the S corporation and the limited liability company, or LLC.
A. Overview of the Corporate Form:
A corporation is a separate legal entity, distinct from the individual(s) who own the business. The owners of a corporation are called shareholders. The shareholders adopt by-laws for the corporation and elect a board of directors. The board oversees the corporation’s policies and decisions, and may appoint officers or hire employees to carry out such decisions as well as to conduct the day-to-day management and operations of the corporation. The shareholders may also opt to personally sit on the corporation’s board if increased oversight is preferred. The rights and abilities of a corporation are similar to those of a natural person—it can be taxed or sued, and can enter into a contractual agreement, for example—with the added advantage of perpetual duration, limited liability for shareholders and easy transferability of interests.
B. Formation of a Corporation
In order to establish a corporation in New York State, one or more individuals who are at least 18 years of age must file a Certificate of Incorporation pursuant to section 402 of the Business Corporation Law. A fillable PDF of the Certificate is available here. The New York Department of State provides additional guidance for starting a corporation on its website.
C. Advantages of the Corporate Form
There are a number of advantages to forming a corporation. A corporation may continue indefinitely, even after the death or incapacity of its shareholders, officers or directors, or if its shares are transferred from one individual to another. Because of its separate legal identity, a corporation is responsible for its own liability and business debts, whereas a shareholder’s liability is generally limited to the amount the shareholder invested, that is, the amount paid for shares of stock in the corporation. A more formal business structure may be more attractive to potential investors, so incorporation can aid in the growth of a business.
D. Disadvantages of the Corporate Form
One major encumbrance to forming a corporation is the administrative cost and burden. There are a number of fees associated with filing a Certificate of Incorporation. In addition, the formation and operation of a corporation involves a great deal of paperwork. Preparing a tax return is a much more arduous process for a corporation. In addition, corporations are required to keep correct and complete books and records of account, and must keep minutes of the meetings of its shareholders, board of directors and executive committee, if any. The corporate books and records are not filed with any state or federal agency, but these internal documents may be audited at any time, so it is in the best interest of the corporation to ensure the completeness and accuracy of its records. Corporations must also keep a record containing the names and addresses of all shareholders, the number and class of shares held by each and the dates when they respectively became the owners of record.
E. Double Taxation
One drawback of the C corporation is that it is subject to double taxation. The corporation’s profits are taxed to the corporation when earned, and then are taxed again to the shareholders when distributed as dividends.
F. S Corporations
An option for small businesses looking to have the advantages of incorporation and avoid double taxation is to form an “S” or small business corporation. Shareholders still benefit from the limited liability of a corporation, but an S corporation is not subject to income tax on its own; rather, only shareholders are subject to a tax on their shares of income, also called the “pass-through” tax treatment. Information regarding federal income tax filing requirements for S corporations and S corporation shareholders is available here. A business must qualify for S corporation status by meeting the following requirements: be a domestic corporation; have only allowable shareholders, including individuals and certain trusts and estates, but not partnerships, corporations or non-resident alien shareholders; have no more than 100 shareholders; have only one class of stock; and not be an ineligible corporation (such as certain financial institutions, insurance companies and domestic international sales corporations). In order to become an S corporation, the business must submit Form 2553 – Election by a Small Business Corporation signed by all the shareholders to the IRS, as well as file Form CT-6 with the New York Department of Taxation and Finance. Additional information and instructions regarding Form 2553 are available here, and instructions regarding Form CT-6 are available here.
Limited Liability Company
A. Overview of an LLC
The limited liability company is a relatively new, hybrid type of business entity that gained popularity in the 1990s. The LLC offers the liability-limiting features of a corporation and the tax benefits and organizational flexibility of a partnership. The owners of the company are called members, and the structure of the LLC allows the members to divide and delineate elements of the business such as management responsibility, profit sharing, funding obligations and dissolution as they see fit. Similar to a partnership, a formal, written operating agreement is not required to form an LLC, however it is advisable to clearly outline each member’s role in the business, and what would happen in the event of a liquidation. A member’s liability is limited to the member’s personal investment in the company.
B. Formation of an LLC
An LLC may be formed by filing Articles of Organization signed by one or more of the organizers with the Department of State. An LLC’s lifespan may be determined by the members when filing this formation document, although the members may vote to extend this time period at the time of expiration.
LLCs share similar administrative cost concerns with corporations, as numerous fees for formation, filing and dissolution are required, as well as potential additional fees for actions such as changing the company’s name. After the organization of an LLC, the organizers must publish notice of the formation once a week for six weeks in two newspapers designated by the county clerk in the county in which the office of the LLC is located. Within 120 days of the formation of the LLC, the organizers must then file a Certificate of Publication, attaching the Affidavits of Publication provided by the two newspapers. An LLC must also pay a fee and file a biennial statement with the New York Department of State setting forth the name and business address of its chief executive officer, the street address of its principal executive office and the address to which the New York Secretary of State may forward copies of process accepted on behalf of the corporation.
C. Choice of Entity
Although filing taxes for an LLC tends to be much more complicated than any other business entity, LLCs may choose how they are taxed (by filing Form 8832 – Entity Classification Election), and have the option to elect pass-through taxation for their members. An LLC with two or more members can elect to be a corporation or a partnership. Information regarding applicability of income tax rules to the two aforementioned situations is available on the IRS webpage. An LLC with one member can elect to be a corporation or elect to be a “disregarded entity” separate from its owners (in effect, to be treated as a sole proprietorship for federal tax purposes.) Additional information regarding single-member LLCs is available on the IRS webpage. Another very helpful and comprehensive resource regarding the taxation of LLCs is Publication 3402 from the IRS. Nevertheless, in light of the potential tax consequences, those interested in organizing an LLC should consult with a tax professional prior to filing.
Choosing a type of business entity is a very important decision for a business owner, and should be made with a careful weighing of the benefits, costs, and the goals you have for your business. It is important to remember that corporate protection of shareholders is not completely fail-safe, as certain instances may allow for the “piercing of the corporate veil.” In addition, certain states hold shareholders liable for unpaid payroll and retirement contributions to employees; New York Business Corporation law allocates this liability to the ten largest shareholders of the corporation. A team of professional advisors (attorneys, accountants, financial advisors) can guide you through the legal process of forming your business and assist you with filing taxes and other administrative concerns. These advisors can help you successfully grow your business and achieve your vision.