Determining the Appropriate Business Entity–Should I Form an LLC or a Corporation?[Note: this post was originally published February 25, 2014. It was last revised May 10, 2018.]
Every potential business owner and service provider should give serious consideration to forming a business entity when they start a business to limit his/her individual liability for the debts and other obligations of his/her business. Having a separate business organization, such as a corporation or limited liability company, may allow you to separate your personal assets from those of your business—and thus protect your personal assets from certain claims against your business.
To achieve this liability protection, you must organize and register your business entity with a State or the District of Columbia when you start a business. You will have a range of entity types to choose from. As a practical matter, however, most new businesses are being formed either as a limited liability company or a corporation.
Tax considerations for when you start a business.
The choice between the two depends on (1) the tax treatment you want for the entity, and (2) the desired ownership structure and management of the entity. Liability protection comes with a choice of tax treatments for the business. For income tax purposes, your business entity will be taxed in one of three ways: disregarded, as a flow thru entity, or as a corporation. If the entity is disregarded for tax purposes or treated as a flow thru, then the entity itself does not pay tax on its income. Instead, the business owner(s) is/are personally taxed on all of the entity’s income.
If the entity is treated as a corporation for tax purposes, then the entity will pay income tax on its earnings. This type of entity is often referred to as a “C-corp.” If the owners of a corporation receive dividends, they also pay individual income tax on those dividends. Currently in most cases at a reduced 20% rate. Such double-taxation of income earned by a corporation can be costly, although that cost may be offset by deductions available only to corporations.
Corporations that meet certain requirements may elect to have S-corporation status, which eliminates the double-taxation issue by allocating the S-corporation’s income and tax liability to its individual owners. In addition, use of an S-Corporation status may, under the right circumstances, limit your payroll taxes. However, S-corporation status brings with it significant restrictions on the structure and ownership of the business entity and eliminates many of the deductions available to C-corps.
The choice of tax treatment is an important financial and tax decision, and best made in consultation with a qualified tax attorney when you start a business. The chart on the following pages summarizes the tax treatment available for a given entity type. Note that while a corporation may be treated as a C-corporation or S-corporation for tax purposes, a limited liability company with two or more members may choose to be taxed as either a corporation or as a flow through entity. And if otherwise eligible, a limited liability company that chooses to be taxed as a corporation may also elect to be taxed as an S-corporation. Accordingly, when you start a business as a LLC you should consult a tax professional for help in determining the appropriate tax status for your new business.
Management of Entity
Separately, when you start a business, you should consider how you are going to organize the management of your business. Corporations have a predictable management structure: its shareholders elect a Board of Directors, who in turn appoint the officers of the corporation, and the officers carry out the corporation’s day-to-day business operations. When you start a business in a C-corporation, different shareholders may have different voting and dividend rights. When you start a business in an S-corporation, all shareholders must have identical dividend rights and those who have voting rights must have the same voting rights. Shareholders in a corporation should enter into a shareholders’ agreement that provides for things such as how they will vote or limitations on the transfer of their shares.
Limited liability companies, on the other hand, can have wide-ranging management structures. Such companies may be managed by all of its owners or by one or more managers, who generally are not required to be owners. All of the operations of a limited liability company are governed by the company’s operating agreement and the applicable state limited liability company rules. Because the operating agreement is so important, it is imperative to put it in writing, even for a limited liability company with only one member. The operating agreement will both lay out the day-to-day decision making procedures for the company and the rules for the interaction of the company’s members. Such rules typically include restrictions on the transfer of membership interests and provisions for distribution to members. The operating agreement should be signed by all of the members, as well as the limited liability company.
The predictability of the corporate management structure can be attractive to outside investors because it does not present the risk that they will be confused by the quirks of a limited liability operating agreement. However, the flexibility of the limited liability company’s management structure enables business owners to exercise effective control over the management of their businesses. The attorneys at General Counsel, P.C. can help you evaluate the pros-and-cons of both possibilities and enable you to make an informed decision when you start a business.
Business Entities Comparison Chart
What’s in a Name: The importance of the public’s knowledge of your business
When you start a business, the name of your business can be critically important in attracting customers. But thinking of a great name is only the first step in a surprisingly complex process for registering the name that the public will know your business as.
The first step is the name of your business entity itself. The entity cannot have the same name as another business in the state in which it is organized. The staff at the Maryland State Department of Assessments and Taxation, Virginia State Corporation Commission or DC Department of Consumer and Regulatory Affairs will be able to tell you whether the name that you are considering is available. If it is, you may register the entity immediately when you start a business or, alternatively, request that the state or District reserve the name for you for several months.
If you always use the full name of your business entity when you market your business to the public, then your registration requirements stop with the business entity. However, if you use a different name, then you must register that as a trade name. (Similarly, if you are sole proprietors but do business under a different name, then you must register that other name as a trade name.) When you start a business in Virginia, you must register the trade name in each county or city in which your entity does business, and you must also register the trade name with the Virginia State Corporation Commission. When you start a business in Maryland and the District of Columbia, a single registration with the state or District government is sufficient.
If you want trademark rights to attach to your business’s name, then you must take additional steps. Trademark rights for a name are based on the use of that name in commerce, not on the name’s registration with state agency that governs business entities. You can improve your claim to trademark rights by registering the name with the United States Patent and Trademark Office. The Intellectual Property practice group at General Counsel, P.C. can help you make that filing and preserve the valuable trademark rights to the name that you created.
Shouldn’t I Have a Delaware Corporation or Limited Liability Company?
Choosing the State of Organization
All fifty states and the District of Columbia authorize the organization of corporations and limited liability companies when you start a business. You can have a particular state issue the charter for your business entity even if you do not conduct business in that state or have any connection with that state. This concept is most famously demonstrated with the Delaware Corporation, where many Fortune 500 corporations are chartered in Delaware even though their business operations are in other states.
This occurs because a business entity’s internal relationships (corporate shareholders-board of directors; LLC member-LLC manager) are governed by the law of the state in which the business entity is organized and registered when you start a business. Delaware corporate law is generally considered to be favorable to corporate management. Delaware also has a very well developed body of case law regarding business and an easily accessible Chancery Court for resolving commercial disputes. For these reasons, publicly traded companies (and many private companies) frequently choose to organize under Delaware law.
For the vast majority of businesses, the choice of the state of organization when they start a business does not have any real impact on its tax liability in the states where the company does business. Thus you are highly unlikely to avoid paying corporate income taxes to, for example, Virginia, on income generated there just because you organized your corporation under the laws of another state.
Most new businesses are best served by organizing as an entity under the law of the state in which most of the business operations will occur. In the Washington, D.C. metropolitan area, Virginia, Maryland, and D.C. law vary in their requirements for corporations and limited liability companies. Although, none of the differences are significant enough to justify the extra expense of organizing an entity in a state where you are not conducting business.
Registering in Other States by Business Conducting Business in More than One State
When you start a business you must register your business entity in every state in which it “does business.” This simple phrase belies some complex analysis. If your business has employees in a state other than the state in which the business entity is organized—even if it’s an employee who frequently travels into the state on sales calls—or if your business does more than occasional business in another state, then the business entity may need to register as a “foreign entity” in that other state. If your business only infrequently provides a service in another state, then it may not need to register in that other state. If you are unsure where your business falls, you should consult one of the business attorneys at General Counsel, PC.
Choosing a Registered Agent
A business entity must appoint an official agent in every state or District in which it is registered and/or doing business. The official title of these agents varies by state (most often they are called a “Registered Agent” or “Resident Agent”), and the laws of the different states’ provide different duties and responsibility to the agents.
In all states, when a business entity is sued the legal papers for the lawsuit may be served on its registered agent. In many states, including Virginia, the agent is also the recipient of all of the official correspondence to the business entity, such as annual renewal paperwork from the state.
Business owners frequently appoint law firms and other specialist businesses to serve as their agent. General Counsel, P.C. serves as a Virginia registered agent for a number of business entities. In addition, a business owner generally may serve as his or her business entity’s agent in the state in which that owner resides.
Writing a Business Plan
Before you begin making decisions about your business, you should organize and formulate your thoughts and objectives by creating a business plan. It does not need to be a formal document, especially in its early stages of when you start a business. A business plan is a living document—you will modify it frequently as you go along.
When you discuss your business idea with advisors, such as an attorney or accountant, the business plan will help them tailor their advice to your precise concept, product or services. Further, when you discuss your business idea with potential lenders or investors, the business plan will provide a take-home piece that demonstrates the viability of your concept. Commercial lenders, including banks, generally will not consider lending to your business if you do not have a well drafted written business plan.
Start a Business: Business Plan Outline
I. Executive Summary: This is a one to two page summary of core ideas for a business plan. The summary should interest a reader in the business concept, product or services and entice him/her to read the entire plan. Even though here, the Executive Summary appears first in the final document, it will typically be written last.
II. Description of Business and Management: This section should give a brief description of your business. Include the name of the business, how it is organized, the identity of the owners, and the history of the business.
III. Description of Product or Service: It is critical to give a clear and concise description of the services to be offered by your business. This section should be written in layperson terms—technical information can be attached in the appendix. You should emphasize the benefit your product or services offer to the target market.
IV. Marketing Plan: The marketing plan should include a review of industry conditions, a precise definition of your target market(s), an analysis of competitor advantages and weaknesses and a plan for promoting and selling your services.
A. Industry: Describe the state of affairs within your industry segment.
B. Customer: In this section, write a clear description of your target market and include their needs and wants. Your service should offer a solution to the target market or provide a benefit to your customer.
C. Competition: This section identifies competitors providing the same or similar solution to your target market. For each competitor, you should define strengths and weaknesses and define how you will position your business in the market with the established firms. Do not assume that you have NO competitors. Somehow, someway, your target market is using a service that meets the need you aim to satisfy.
D. Advertising and Promotion: In this section you should define how you intend to get your service to your target market. This includes marketing avenues—advertising, promotions, public relations—and distribution channels.
E. Location: Describe the location of your business and how its features impact your business. If the business requires special zoning or building improvements, note them here.
V. Subcontractors: If you depend on subcontractors to deliver a service, you should know how to contact these sources. In this section you will list your critical subcontractors.
VI. Management Capabilities: It is important to know what resources you have in-house to support business development and growth and what resources you will need to find. In this section, you should demonstrate that your management team has technical abilities, marketing abilities and business acumen to succeed. In addition, identify directors and advisors who you will consult with.
VII. Financial Plan: This section should include past financials and future projections based on sound and reasonable assumptions. If the business plan is being presented for financing, the source and use of funds should be defined here.
No Obligation Consultation: If you would like to arrange a no obligation consultation to discuss your business goals and appropriate entity for your business feel free to call Norman L. Eule, Esq., Chair of General Counsel P.C.’s Corporate and Tax Group at 703-556-0411, or e-mail him at email@example.com.
*The foregoing is not intended to provide, nor should it be relied upon for, legal advice. Nor is it intended to establish an attorney-client relationship with General Counsel, PC.
General Counsel, P.C. – Every Business Needs a General Counsel: Led by Norman Eule, General Counsel’s Business and Tax Practice Group has over 40 years of professional experience in counseling business owners on all aspects of commercial transactions. Our attorneys have extensive experience representing a wide range of local, regional, and national companies and business ventures. If you have any questions regarding the effect of the new solicitation rules on your company, or any other business law related questions, please contact either Norman L. Eule or Robert Lee.