Incorporating 101

Incorporations, LLCs, and Subchapter S Corporations

Description of a corporation, LLC and S corporation
Structure of a corporation, LLC and S corporation
Advantages of a corporation, LLC and S corporation
Limitations of a corporation, LLC and S corporation
Management of a corporation, LLC and S corporation

Description of Each

Corporation

A corporation is a separate legal entity that exists independently from its owners. A corporation is created and comes into existence when articles of incorporation (charter or certificate of incorporation in certain states) are filed with the proscribed fees, and accepted by the proper state authority.

S Corporation

An S Corporation is merely a corporation which has elected a special tax status with the federal government. It was created for smaller business owners. The special tax treatment permits the income of the corporation to be treated like the income of a partnership or sole proprietorship in that the income is “passed through” to the shareholders.

In order to be considered an S Corporation, the stockholders of a properly filed corporation must elect such status within 75 days of formation for the current tax year, or at any time during the preceding tax year. This election is made by filing Form 2553 with the IRS. To qualify for S Corporation status:

Must be a domestic corporation.
Only one class of stock.
Not more than 75 stockholders.
Stockholders must be individuals, estates or certain trusts.

Except for the above characteristics, an S Corporation follows the same guidelines as a regular “C” Corporation.

Limited Liability Company

A Limited Liability Company (“LLC”) is a separate legal entity that offers an alternative to partnerships and corporations by combining the corporate advantages of limited liability with the partnership advantage of pass-through taxation. An LLC is created and comes into existence when articles of organization are filed with the proscribed fees, and accepted by the proper state authority.

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Structure of Each

Corporation

A corporation is owned by stockholders. While stockholders do not directly manage the corporation, they influence corporate decisions through indirect actions such as electing and removing directors, approving or disapproving amendments to the articles of incorporation, and voting on important corporate decisions.

The members of the Board of Directors are responsible for managing the affairs of the corporation. Usually, directors make only major business decisions, however they supervise and appoint officers who make the day-to-day business decisions of the corporation.

Officers are responsible for the everyday management of the corporation.

Typically, officers are appointed directly by the Board of Directors.

A stockholder may serve on the Board of Directors and also be an officer of the corporation. In fact, in most states one person is enough to form a corporation, and that person can be the sole officer, director and stockholder.

S Corporation

An S Corporation follows the same structure as a regular corporation. However, an S Corporation is usually owned and run by a small number of individuals or family members (one or more). Thus, while the above structure applies, the same person or related persons or a small number of persons MAY control all positions.

Limited Liability Company

An LLC is owned by its members. The members of an LLC are like partners in a partnership or shareholders of a corporation. A member will more closely resemble a shareholder if the LLC utilizes a manager or managers, because under that situation the members will not participate in the management of the LLC. However, if the LLC does not utilize managers, then the members will more closely resemble partners because they will have decision making powers in the LLC.

The member’s ownership in the LLC is represented by their respective “membership interest”, in the same manner as a partner has an “interest” in a partnership or a shareholder has stock in a corporation.

Most states require LLCs to have at least two members. The states which allow one member LLCs are DE, ID, MO, MN, NY, TX and VT.

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Advantages of Each

Corporation

The most important advantage of incorporation is that it gives its stockholders limited liability. Since the corporation is a separate legal entity, its stockholders are protected from the debts and liabilities of the corporation. Other advantages include:

A corporation has unlimited life.
If an owner dies or sells his interest, the corporation will continue to exist.
Ability to easily establish insurance and retirement plans.
Ownership of a corporation is easily sold or transferred through sale or transfer of stock.
Capital can be raised through the sale of stock.
A corporation has centralized management that may remain in place after a sale.

S Corporation

The special tax treatment permits the income of the corporation to be treated like the income of a partnership or sole proprietorship in that the income is “passed through” to the shareholders. Thus, shareholders report the income or loss that is generated by an S Corporation on their individual tax returns. Under these circumstances the “double taxation” potential is avoided.

Limited Liability Company

Taxation: Pass-through taxation LLCs allow earnings of an LLC to be taxed only once. The earnings from an LLC are treated in a similar manner as earnings from a partnership, sole proprietorship and most S Corporations.

Limited Liability: The member’s liability is generally limited to the amount of money which the member invested in the LLC. As a result, the members of an LLC receive the same limited liability protection as do shareholders of a corporation.

Flexible Organizational Structure: LLCs are generally free to establish any organizational structure agreed upon by its members. Thus, profit interests may be separated from voting interests.

In general, the disadvantages of either entity might include:

Complexity and expense of forming a corporation or LLC.
Legal formalities involved with running a corporation or an LLC.

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Limitations of Each

Corporation

The primary disadvantage to incorporation is the possibility of double taxation. The profits of a corporation are taxed twice when the profits are distributed to shareholders as dividends. They are taxed first as income to the corporation, then second as income to the shareholder. However, all reasonable business expenses such as salaries and other operating expenses are deductions against corporate income that can minimize double taxation. “Double taxation” can be eliminated by making an S Corporation election.

S Corporation

Must be a domestic corporation.
Only one class of stock.
Not more than 35 stockholders.
Stockholders must be individuals, estates or certain trusts.

An S Corporation cannot have shareholders who are C-Corporations, other S Corporations, certain trusts, LLCs, partnerships or nonresident aliens. S Corporations are not allowed to own 80% or more of another corporation’s shares.

Limited Liability Company

Possibility of losing pass-through taxation if the LLC is not properly structured.
More paperwork than an ordinary partnership.

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Management of Each

Corporation

A corporation is owned by stockholders. While stockholders do not directly manage the corporation, they influence corporate decisions through indirect actions such as electing and removing directors, approving or disapproving amendments to the articles of incorporation and voting on important corporate decisions.
The members of the Board of Directors are responsible for managing the affairs of the corporation. Usually, directors make only major business decisions; however, they supervise and appoint officers who make the day-to-day business decisions of the corporation.
Officers are responsible for the everyday management of the corporation. Typically, officers are appointed directly by the Board of Directors.

Number of Directors

Generally, in most states a corporation is only required to have one director, however you are permitted to have more. However, certain states base the required number of directors on the number of stockholders. If the corporation has 3 or more stockholders, then the corporation must have at least 3 directors. If the corporation has less than 3 stockholders, then the number of directors may be equal to or more than the number of stockholders. The states which have this rule are CA, CO, CT, HI, LA, ME, MD, MA, MO, NY, OH, VT and UT.

S Corporation

An S Corporation follows the same guidelines as a regular corporation. However, an S Corporation is usually owned and run by a small number of individuals or family members (one or more). Thus, while the above structure applies, the same person or related persons or a small number of persons MAY hold all positions.

Limited Liability Company

An LLC is owned by its members. The members of an LLC are like partners in a partnership or shareholders of a corporation. If the LLC is managed by its members, then it operates much like a partnership. Each member shares equally in the decision making process of the LLC.

Alternatively, the members may choose to appoint a manager or managers to act in a capacity similar to a corporation’s board of directors. The managers are then in charge of the business affairs of the LLC. If managers are not designated in the articles of organization, the members will be deemed to direct the business affairs of the LLC.

A member will more closely resemble a shareholder if the LLC utilizes a manager or managers, because under that situation the members will not participate in the management of the LLC. However, if the LLC does not utilize managers, then the members will more closely resemble partners because they will have decision making powers in the LLC.

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