Sunday, July 8, 2012

Selection of the Right Legal Entity for Your Business: LLC vs S Corp (a New York Perspective)

One of the most common questions I get asked by my clients is whether the new business should be formed as an LLC or an S corp. I address this question below.

If I were to summarize this blog in one sentence, then it would be this: the choice of entity is not just a legal question, also involves an analysis of accounting and tax considerations that vary according to the founders’ particular situation. So, in addition to a consultation with an attorney, it is important to schedule a consultation with your accountant. Skipping this step may result in unintended tax consequences and also in legal fees if the owners need to restructure their business entity later on.

Below is a quick summary of legal considerations pertaining to S corporations and LLCs in New York.

S corporation

Corporate structure:

  • Separate Legal Entity:  An S corporation is a separate entity with a legal personality, which means that it can sue and be sued, and it can own property.
  • Corporate Formalities:  It is important for an S corporation to maintain corporate formalities: open separate bank accounts, conduct period meetings of the board of directors, document decisions in a minute book, etc.
  • Management:  An S corporation has centralized management, vested in a board of directors elected by the shareholders. The board oversees the strategic decisions of the corporation and appoints officers who deal with the daily operations of the company. Directors, officers and majority shareholders own fiduciary duties to the shareholders of the corporation.
  • Limited Liability:  Shareholders, directors and officers typically have limited liability for debts and obligations of the corporation, as long as the “corporate veil” is not pierced (this can happen if, for example, corporate formalities are not preserved or there is commingling of funds or fraud).
  • Shareholders Agreement:  It is advisable, but not required, that shareholders enter into a shareholders agreement that outlines internal governance rules of the corporation, such as when shareholders can be admitted to the corporation or resign from it).
  • Buy-Sell:  It is also recommended that shareholders enter into buy-sell agreements.

Special considerations:

  • An S corporation is a regular business corporation that has elected special tax treatment on the federal and state level (New York City does not recognize “S” corporation status).
  • Only US citizens or residents can be shareholders of an S corporation.
  • An S corporation can have only up to 100 shareholders, and all shareholders must be individuals (another corporation or an LLC cannot be shareholders of an S corporation).
  • All shares must have the same economic rights to profits, distributions and liquidation of assets. This means that even though an S corporation can have voting and non-voting shares, it is not possible for an S corporation to issue preferred stock, since it would have different rights to distributions and a different liquidation preference than common stock.

Tax Considerations:

  • An S corporation has “pass-through” tax treatment at the federal and state level.
  • Shareholders of an S corporation who work for the business are considered to be employees and have to pay themselves a reasonable salary (it may result in tax savings as compared to self-employment tax for LLCs but has increased maintenance costs related to payroll).

Limited Liability Companies

Corporate Structure:

  • Separate Legal Entity:  Just like an S corporation, an LLC is a separate legal entity; it can sue and be sued and it can own property.
  • Corporate Formalities:  Unlike an S corporation, an LLC has to maintain only minimum corporate formalities, although it should still have a separate bank account to avoid commingling of business and personal funds of the owners.
  • Management:  In terms of management, LLC is very flexible: it can be member- or manager-managed; it can be run like a corporation, a general partnership or a limited partnership. If the owners so desire, it can have a board of directors, and can refer to its membership interests as “shares”.
  • Limited Liability:  There is limited liability protection for the members and managers of an LLC, absent commingling of funds, fraud or, in cases of single-member LLCs, if the LLC is just an alter-ego of its owner.
  • Members:  LLC can have from one to unlimited number of members, including non-US citizens or entities
  • Operating Agreement:  In New York, all LLCs must enter into an operating agreement within 90 days of formation.
  • Special Allocations:  LLCs allow special allocations of profits and losses among members: members can agree to share profits and losses in proportions different from their membership interests. For example, members can agree that 100% of the profits of an LLC be distributed to one member for the first three years, despite the fact that that member owns only 50% of the LLC and normally should have received only 50% of the profits and losses.

Special Considerations:

  • Publication Requirement:  Within 120 days of formation, all LLCs organized in the State of New York must publish a notice of formation in two newspapers selected by county clerk of the county where the LLC was formed. This can be expensive: publication costs in New York county (Manhattan) are around $1,300.
  • Consequences of not publishing on time:
    • LLC will lose authority to do business in NY
    • It cannot sue anyone in New York courts, but can defend itself
    • Members may lose limited liability protection.
    • There is no penalty or fine for complying with this requirement late.
    • Contracts of an LLC that has not complied with the publication requirement are still enforceable.

Tax Consequences:

  • LLC enjoys a “check-the-box” taxation: it can elect to be taxed as a disregarded entity, a partnership or a corporation.
  • If no election is made, a one-member LLC will be treated as a disregarded entity at the federal level; and a multi-member LLC will be treated as a partnership. In such cases, the LLC itself does not pay taxes, but files an informational return.
  • Members who are actively involved in the business of the LLC pay a 15.3% self-employment tax on 92.35% of net earnings up to $106,800 and everything above is taxed at 2.9%.
  • LLCs are subject to New York City’s 4% UBT.
Business founders should work together with the attorneys and accountants to determine the best legal entity structure for their business. This will depend on a number of factors, including, but not limited to: the immigration status of the founders, plans to seek outside capital from professional investors, start-up costs, tax consequences, and the desirability of special allocations of profits and losses.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

5 comments:

  1. I am planning to file an llc company. Thanks for your post, I now know the difference between an S and an LLC company. Keep posting, you're a great help to us who's into forming business entities.

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  2. I found it to be very costly. Do you have some cheap offers?

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  3. The difference is mighty clear. This description would help a lot of people trying to file an LLC or incorporate their business.

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  4. Thanks for all your efforts that you have put in this. Very interesting info.

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  5. One of the things that should be taken into consideration is that taxation issue in putting up an LLC company. The tax, together with the division of profits based on percentage of stock share should not be taken lightly. It should provide satisfaction to the investors for the company to sustain the challenges ahead.

    ReplyDelete