So you are opening up your own business or maybe you just purchased a rental property and want to know the best type of entity to set up for you and your partners. In general, there are really two options, you can either set up an LLC or a corporation.
Although in certain situations there are other factors to consider, there are five major factors that you should think about with your advisors in making this decision:
1. Limiting Your Personal Liability. The most important reason for you to set up an entity for your business or rental property is to limit your personal liability related to its operation. If you just owned the business yourself or as a general partnership with the other owners, then a creditor of the business could come after you personally for a liability of the company. However, with some exceptions (which I will address in another blog), if you set up an LLC or a corporation, then business creditors can come after the assets of the business only, and not after your assets individually. This protection from personal liability is critical for your piece of mind in protecting your family.
2. Tax Considerations. Corporations can be treated as a C corporation or as an S corporation for tax purposes. The forms that you file with the State are the same for either type of corporation, but there is an additional form that you file with the IRS in order to elect S corporation status. For tax purposes, any profits for a C corporation will be taxed at the corporate level, and then any distributions to the shareholders will also be taxed on each shareholder’s individual return. This is sometimes referred to as “double taxation”. S corporations, on the other hand, do not have double taxation, and any profits of the corporation “flow through” to the shareholders’ individual 1040 returns on a pro rata basis. As a result, this is sometimes referred to a “flow through” tax treatment. An LLC can be treated as a C corporation, an S corporation, a partnership, or a “disregarded entity” (usually this is used for single member LLC or for a husband and wife who own an LLC). Thus, an LLC provides the most flexibility in choosing the tax treatment that you want. Of course, you should always discuss the tax treatment decision with your accountant first before making this important decision.
3. Who Can Be an Owner. S corporations have certain restrictions about who can be a shareholder. Only individuals, certain trusts, and estates can be shareholders of an S corporation. In addition, corporations, partnerships, and non-resident aliens may not be shareholders in an S corporation. Finally, there can only be one class of stock and no more than 100 shareholders in an S corporation. C corporations and LLC’s do not have these restrictions.
4. Flexibility with Distributions. Although there may be different classes of stock in a C corporation, such as preferred stock and common stock, most closely held corporations have one class of common stock, and the distributions for such stock is required to be made to the owners on a pro rata basis according to their ownership. If an LLC chooses to be treated as an S corporation for tax purposes, it will have the same requirement. However, an LLC that is treated as a partnership for tax purposes can have incredibly flexible distribution provisions and is not limited to pro rata distributions. For instance, in an LLC, the first $100,000 of profit could be distributed to one of the two partners (maybe the one who put up most of the initial capital), the next $100,000 of profit could be distributed 75/25 among the partners, and any profits thereafter could be distributed 50/50 among the partners. Losses can also be allocated in special ways, and profits thereafter can be allocated to the specific partners who incurred the losses. This type of flexibility is simply not possible with a corporation.
5. Set-Up Costs, Ongoing Maintenance, and Annual Filing Fees. If there are no unusual provisions to be included in the formation documents, then the initial cost to set up a corporation and the initial cost to set up an LLC will be about the same. Any unusual provisions will cause the cost of the LLC set-up to be higher because of the additional drafting required in the LLC’s Operating Agreement. However, the real difference is in the ongoing maintenance costs and filing fees for each entity. With a corporation, annual minutes must be prepared and maintained and an Annual Report must be filed with the Arizona Corporation Commission (ACC) each year. While it is certainly possible that the ACC could require these things for LLC’s in the future, currently there is no requirement in Arizona for either annual minutes or an Annual Report for an LLC.
Thus, because of its tremendous flexibility, my experience has been that LLC’s are generally the best choice for clients most of the time.
Our firm has helped hundreds of families just like yours handle a wide variety of business planning, estate planning, probate, and elder law issues. When families or business owners are not getting along, we can also handle any disputes and litigation related to their businesses, wills, trusts, guardianships, or conservatorships. Please give me a call, so that I can help you work through these difficult issues with confidence.