Choosing a Business Entity in Virginia - May 2016
“I want to form a business, what type of entity should I choose?” As a business attorney, this is a question that I frequently run across. The choice of a business entity is one of the first questions that a new start-up should address and is more nuanced that many might think. To answer the question properly involves an analysis of the legal, tax and management objectives of the business owner. An owner looking to set up a real estate holding company will answer the question very differently from someone looking to set up a personal service company. Someone planning to take their business public will have different requirements than someone setting up a family business. In Virginia there are numerous structures available to a new business owner, however, the most common are the sole proprietorship, limited liability company, corporation and S-corporation. Below I briefly discuss each of these common structures and some of the aspects that differentiate them. Please keep in mind that choosing the right business form requires a balance of functional, tax and legal considerations and should be undertaken with appropriate professional advice.
This is the simplest and least expensive business structure to set up and operate and simply involves an individual opening and operating a business. There is no actual entity to set up and no difference between the individual and the business. The biggest drawback to this structure is the complete lack of any liability protection. An individual operating a business as a sole proprietorship is personally liable for all of the businesses debts and liabilities of the business and any creditor will not only be able to look to the assets of the “business” but also the personal assets of the individual, including bank accounts, cars, etc. For this reason, the sole proprietorship is almost never recommended. Interestingly, there continue to be a fair number of sole proprietorships, most simply through a lack of planning or knowledge.
A corporation (really a “C-corporation”) is what many people have in mind when they think of a “business”. C-corporations are entities that are formed by filing Articles of Incorporation with the state where they are formed and are subject to strict organizational and operating formalities. While there are some variations from these rules, corporations are required to have stockholders, directors and officers, hold regular annual meetings, adopt bylaws and record corporation actions in a corporate record book. The corporation is a separate legal entity from its stockholders and provides liability protection to its owners, meaning that the stockholders are not liable for the company’s obligations. C-corporations provide a lot of flexibility in their ownership structure and can have multiple categories of stock with different rights and values. There are virtually no restrictions on the number or types of stockholders. These characteristics make them an attractive option for big businesses that have or expect to have a large number of owners and/or seek to “go public” in the future. The biggest drawback of C-corporations is that they are subject to two levels of taxation, one at the entity or company level and one at the stockholder level. This can result in more tax being paid when compared to some other entity options and generally is more costly to administer.
S-corporations (“S-corps”) are C-corporations with a twist. S-corps are so named because they are C-corporations (although other entities can now make the same election, see limited liability companies below) that have made an election under Subchapter S of Chapter 1 of the Internal Revenue Code to be taxed as a “pass through” entity. Just like their cousins, C-corporations, S-corps have stockholders, directors and officers and enjoy limited liability (meaning the stockholders are not personally liable for the obligations of the company). However, unlike a C-corporation and due to the Subchapter S election, there is only one level of tax paid on the income generated by an S-Corp business. For tax purposes, all of the income, deductions, and tax credits of an S-corp flow through to stockholders and are reported on the stockholders’ income tax returns. In exchange for this tax advantage, S-corps are restricted to 100 stockholders (husbands and wives are considered one stockholder), stockholders must generally be individuals who are citizens or permanent residents of the U.S. Also, there cannot be more than one class of stock, meaning that all stockholders must share equally in distributions and liquidation proceeds (although non-voting stock is permitted). Despite these restrictions, for many small businesses, the S-corp is a very good option.
Limited Liability Company.
The limited liability company or LLC is a relatively recent addition in the legal world. Sharing many of the tax characteristics of an S-corp, LLCs offer much more flexibility with most of the same benefits. LLC’s offer limited liability to their owners just like C-corporations and S-corps. Owners are called “Members”. LLCs do not require the formal organizational structure that corporations are subject to and are not required to have any directors or officers or hold annual meetings. Further, LLCs are not restricted in the types of people or entities that can be owners. Members can allocate income and losses amongst themselves in almost any manner they desire, allowing for much more flexibility in structuring ownership when compared to an S-corp. In addition, an LLC can make an election to be taxed as a regular C-corporation if desired and, if it meets the requirements under Subchapter S of Chapter 1 of the Internal Revenue Code, elect to be taxed as an S-corp. Why would anyone do this? Well, one of the few differences between the tax treatment of S-corps and LLCs is that all of the income generated by a LLC is subject to employment withholding taxes while an S-corp can make distributions to its stockholders that are not subject to withholding taxes as long as the stockholder is paid a reasonable salary. There are also other tax differences between LLCs and S-corps that make one or the other structure better or worse for different business activities. Interestingly, one of the most significant advantages of a LLC can be one of its biggest drawbacks; its flexibility. Because there are so many ways that an LLC can be set up, from management structure to tax classification, it can sometimes seem overwhelming to establish the right approach. Nonetheless, the LLC is one of the most popular choices for new small businesses today.
Choosing an entity type is a critical step when setting up a new business. Care must be taken to ensure that the owner’s near term and long term needs are met. Competent professional advice in making this decision will enable a new business owner to choose the most appropriate entity form for their situation.
For more information, please contact Pender & Coward's corporate and transactional team.