In general, there are only two types of legal company entities: a limited liability company (“LLC”) and a corporation (“Corp”). Not to confuse matters, the Corp can also be designated as a Statutory Close Corporation (“Close Corporation”). Many clients ask about an S-Corp and often interchange Close Corporations with S-Corporations. Both S-Corp and C-Corp are tax designations, which will be described more fully below.
Limited Liability Company ("LLC")
LLC’s are a popular business entity because they are more flexible and require less corporate governance. An LLC is formed through the Secretary of State’s Office by filing the Articles of Organization. An LLC’s owners are called members, and an LLC can either be single-member or multi-member. An operating agreement is usually necessary to show how the company is to be run, and in multi-member LLC’s it is what many consider to be the “partnership agreement.” An LLC does not require a board of directors, though some have a board of advisors. For tax purposes, LLC’s are considered a “pass-through” entity, as the LLC is not taxed and instead its members are taxed personally. The default taxation for an LLC is as a sole proprietor for single-member and partnership for multi-member. An LLC can also make an S-Election and be taxed as an S-Corp (remember IRS tax designation, not a legal entity), if the proper document is filed with the IRS.
One disadvantage to an LLC is that the company cannot issue stocks and bonds. This makes investments more difficult by third-party investors, and therefore less attractive. This is not to say investment is not possible, but if a company’s strategy is angel or venture capital investment, the best solution is through a C-Corp, which will be described below.
In general, a corporation is a robust business entity that’s primed for growth, but requires meticulous corporate governance. The entity is created by filing Articles of Incorporation with the Secretary of State’s Office. The owners are called shareholder’s and the only requirement is for the corporation to have one shareholder. Corporations require a board of directors, and the operating document is called the by-laws. Often times, corporations will also have a shareholder agreement as well as a shareholder management agreement. A corporation must hold annual meetings, and minutes of the meeting must be kept. By default, a corporation is taxed as a C-Corp (again, this is an IRS tax designation, not a legal entity). A corporation can elect to be taxed as an S-Corp, if the proper document is filed with the IRS.
S-Corp vs C-Corp
There is still one more legal entity to describe. However, at this point, it may be prudent to look at the differences between an IRS designated S-Corp and C-Corp.
A corporation being taxed as a C-Corp is subject to “double taxation.” A C-Corp is taxed at the corporate level and then again as shareholders are taxed on dividends they receive. This money is taxed twice; hence “double taxation.” The advantage of a C-Corp tax basis is its attractiveness to investors. C-Corps can issue stocks and bonds (including different classes and types), making it easy for investoors to invest and for the company to raise capital and grow. Also, corporations can go public, in which an S-Corp or LLC for that matter, cannot. Additionally, C-Corps may have an unlimited number of shareholders in which individuals, companies, and foreign investors may be shareholders.
A corporation who files the proper documentation with the IRS may be taxed as a Subchapter S Corporation. The entity is not taxed on the corporate level, and instead is taxed as a “pass-through” entity, akin to the LLC. The largest difference with the taxation is there is no 15% self-employment tax, which is assessed under an LLC, without S-Corp tax basis. Under the S-Corp, the entity avoids the double taxation that it would otherwise be subject to under C-Corp status. This tax designation can often present issues for investors: the stocks and bonds are highly restricted from transfers, if applicable, and can only have one class; the corporation can only have 100 shareholders at any time; no shareholder can be a foreign investor; and all shareholders must be natural persons (and not another legal entity).
Statutory Close Corporation ("Close Corporation")
The last type of legal entity is a Statutory Close Corporation and it is similar to a regular corporation, but it does not require as strict corporate governance. The intent is for a smaller company, think “mom and pop” shops or family business, to be protected from personal liability while not burdening the small company with strict corporate governance. The entity is formed by filing Articles of Incorporation with the Secretary of State’s Office, but a designation must be made for Statutory Close Corporation on the Articles, or a similar designation dependent upon the jurisdiction (also referred to as Close Corporation or Closely Held Corporation). The owners of a Close Corporation are called shareholders, and the entity does not require a board of directors nor an annual meeting. The shareholders may have a shareholder agreement and shareholder management agreement, in which the transferring of shares is usually highly restrictive, but bylaws are not required. The shares are generally subject to severe transfer restrictions, with transfers limited to the corporation, existing shareholders and family members unless unanimous consent of the remaining shareholders is obtained. By default, Close Corporations are taxed as C-Corps, but the shareholder(s) can elect to be taxed as an S-Corp, if the proper document is filed with the IRS.
In short, there are only two real legal entities, LLC and corporation, in which the corporation can be designated as closely held or a Close Corporation. The terms S-Corp and C-Corp refer to IRS tax designations, and while the designations can have some minor effect on the legal entity, the overall legal structure remains the same, especially for naming conventions. Whether you are creating a start-up, a “mom and pop” shop, or future Fortune 500 company, it is important to consult with an experienced attorney to discuss the options and which entity works best now and in the future. Your business is one of a kind, why shouldnt your legal counsel be as well.