In the Beginning: Choosing the Right Corporate Entity
BY MANLEEN SINGH
Professionals have a wide range of corporate entities to choose from when setting up their businesses, such as corporations, limited liability companies (LLCs), limited liability partnerships, limited partnerships, general partnerships, and sole proprietorships, each with its own advantages and disadvantages. The right entity will depend on the priorities of the owners. Do the owners want to participate in the management of the company? Do they want to customize arrangements with co-owners for a particular endeavor? What about their personal liability, or how much they or the company pays in taxes? It is important to ask and answer these questions at the outset to determine the right fit for the business and its owners. This article explores the characteristics of the two most common forms of corporate entities to inform that analysis: corporations and LLCs.
The traditional corporate form is the corporation, with the usual corporate trappings — shareholders who own the corporation and the board of directors who manage it. Being a shareholder has its advantages. They rarely participate in management of the company, do not owe fiduciary duties to the corporation or anyone else (unless in closely held corporations), and are shielded from personal liability for the corporation’s debts beyond the amount of their contributions, all while pocketing the earnings of the corporation. Shareholders can also freely transfer their ownership interests at will, absent any agreement to the contrary. Minority shareholders in closely held corporations are afforded additional protections, which include investment rights, profit rights, and voting rights, among many others. Even though shareholders do not manage the company, they elect the directors who do. Those directors are not free to manage and operate the company as they please, but rather, they must comply with their fiduciary obligations to both the company and the shareholders.
The typical form of a corporation is a C corporation, but it has one significant drawback — it is subject to double taxation. Taxes are first imposed on the corporation itself and then again on shareholders when corporate earnings are distributed via dividends. While the 2017 Tax Cuts and Jobs Act reduced the corporate tax rate from 35% to 21%, the double taxation feature still exists.
The corporate answer to double taxation is the S corporation. S corporations are hybrid entities in that they are pass-through entities for tax purposes (like LLCs and partnerships) but are still corporations that are governed under states’ business corporation laws with traditional corporate formation concepts (e.g., incorporation documents, by-laws, shareholder agreements, etc.). Not just any corporation can elect to be treated as an S corporation. Only small-business corporations that can satisfy certain elements, such as having no more than 100 shareholders, qualify as S corporations.
LIMITED LIABILITY COMPANIES
LLCs have become the favored corporate form since Wyoming enacted the country’s first LLC legislation, in 1977. The top three benefits of LLCs are single taxation, limited liability, and flexibility. Provided the proper election is made, LLCs are pass-through entities, where taxes bypass the companies themselves and are imposed directly on their owners. Owners also have limited liability, regardless of whether they are involved in management of the company or not. In contrast, partners in certain partnerships are liable for debts and obligations of the company. LLCs also offer flexibility in corporate governance by virtue of the freedom of contract. Owners are free to contract as they wish in the operating agreement (also called “limited liability company agreements”). In fact, the freedom to contract is a key policy consideration for states enacting LLC legislation. For instance, in its Limited Liability Company Act, Delaware confirms that contractual freedom is one of the driving forces — “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” 6 Del. C. § 18-1101(b) (2021).
With contractual freedom, business partners can contract as they wish regarding governance in a given LLC. This means that corporate professionals can tailor LLCs to their particular circumstances and business purpose. They can remove protections provided by state law, such as fiduciary duties of loyalty or corporate opportunity or owner approval of certain transactions. They can add restrictions on transfers of ownership interests, or provide for rights of first refusal. Should a dispute arise, they can mandate arbitrations or require resolution by mediation prior to formal court proceedings. The opportunities are endless for what owners in an LLC can agree to regarding corporate governance.
Such benefits, however, are not without risk. Without mandatory protections afforded to corporations, less sophisticated owners in an LLC may contract away desired protections generally afforded to corporations. Contract law, including law regarding contract interpretation, also applies. Thus, careful attention should be paid to drafting operating agreements to ensure no provisions are stricken for ambiguity. Also, an agreement to agree on a certain subject matter in the future is no agreement at all. It is always recommended to identify and confirm as many terms as possible in the present as opposed to punting the issue down the road and risk the very real possibility that an agreement may not be reached.
The start of a business is an exciting time for owners and entrepreneurs. But that excitement should not rush the important decision of what corporate form the business should take. It may not be conceivable in the beginning, especially in the flurry of activity for a nascent business, but disputes among owners can arise. The first step in resolving that dispute, whether in litigation or not, is always a review of the corporate formation documents to determine the rights, liabilities, duties, and obligations of the parties involved and to inform strategy moving forward. It is important to get it right at the beginning.
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