This article summarizes the benefits
and drawbacks of incorporating versus forming a limited liability
company ("LLC"). While a complete analysis of every difference is
beyond the scope of this article, I will discuss the major factors,
and perhaps mention some other issues in passing.
The primary advantage to incorporating
a business is limited liability. While unincorporated individuals
and partnerships are unprotected from claims of clients, creditors
and others, corporate shareholders' liability is limited. Unless
the shareholder personally guarantees an obligation of the corporation,
the shareholder will not be liable on it, so long as the corporation
jumps through the hoops required by law. That is, if the business
is carried on in the name of the corporation, its funds are not
commingled with those of the shareholder, it observes the corporate
formalities of minutes, bylaws and so forth, files tax returns and
officer statements, etc., only its assets, and not those of the
shareholders, will be liable to claims of creditors of the business.
second advantage of doing business in the corporate form is that
tax rates on net income in certain ranges may be lower than the
rates on individuals. However, this advantage is probably eliminated
by existing tax cut legislation. Furthermore, it is likely outweighed
by the fact that if there are cash profits at the corporate level,
and you wish to pass them to the shareholders (as dividends), to
some extent they may be taxed twice. The specter of double taxation
will deter many businesses from incorporating if they both expect
significant profits and desire to distribute those profits to the
shareholders currently. Of course, your accountant will do his best
to minimize the corporation's tax profits.
avoid double taxation, the corporation will have to spend money
on, for example, your salary, your pension plan and other employee
benefits, etc., so that ideally at the end of the year little net
income will remain. That is, unless the business is making so
much money that you cannot avoid paying the double tax.
Another way to minimize double taxation
is to elect S corporation status. In a nutshell, the profits of
an S corporation are reported on its shareholder's tax return; income
is not taxed at the corporate level. S corporation pass-through
treatment is most useful in three situations:
The business incurs losses
useful as a deduction to the shareholder
The business has excess
cash (after paying a healthy but reasonable salary and pension
contribution) and wants to distribute it to the shareholders
The corporation has appreciating
assets (such as real estate) which would be double taxed on
Nevertheless, in real estate ventures,
and other businesses or investments where leverage is important,
I discourage the use of the S corporation, for tax reasons. The
rule is that shareholders cannot take a tax deduction for their
share of corporate expenses without sufficient basis in their investment.
"Basis" is a tax term meaning the amount of cash and other assets
you contribute to the venture. Concurrently, S corporation shareholders
cannot receive basis in nonrecourse debt, which is a major attribute
of most real estate ventures. Because real estate financing typically
relies solely on the property itself as security for repayment of
the debt, it is said to be "nonrecourse" with respect to the property's
owners. Finally, to get around this limitation, the shareholders
must lend money to the corporation directly; a guaranty of or cosigning
the obligation does not work.
A corporation or other entity can provide
many benefits to its employees. One popular benefit is a medical
expense reimbursement plan, which reimburses employees for medical
expenses not otherwise covered by insurance. The advantage to such
a plan is that while non-self employed individuals may deduct such
expenses only to the extent they exceed 7.5% of their adjusted gross
income, the corporation can deduct the payments in their entirety.
Additional benefits that a corporation may offer to its employees
include a health and accident plan, a cafeteria plan, and nonqualified
The major disadvantage of any business
entity is the cost and additional administrative burdens:
Your corporation must
have its own checking account.
must be observed, and filings must be made.
There will be additional
legal and accounting fees as a result. The cost of incorporating
will include filing fees, minute book, stock certificates, corporate
seal, and legal fees for articles of incorporation, bylaws,
initial minutes, preparation of filings, etc.
You can expect additional
annual legal fees for corporate maintenance.
On the other hand, for many new entities,
and real estate ventures in particular, the form of choice is the
LLC. If the LLC meets certain criteria, it is taxed as a partnership
for tax purposes and also provides the limited liability of a corporation.
You could say it offers the best of both worlds without the drawbacks
S Corporations have three primary drawbacks,
which LLCs avoid:
The S corporation is
limited to 75 shareholders, none of which can be foreigners,
domestic corporations, or co-owners of partnerships.
An S corporation may
not own more than 79 percent of another corporation.
The S corporation has
less flexibility in allocating items of profit and loss among
the investors than does an LLC.
The biggest drawback of the LLC is its
initial cost. Every LLC should have an operating agreement, which
contains all of the tax provisions applicable to partnerships. The
other drawback of using an LLC in a multijurisdictional setting
is that a few states do not yet recognize the LLC as an entity,
which could affect its members' limited liability if the LLC does
business in those states. This should not be a problem where the
nature of the business places it in a specific California location.
Finally, you should be aware of the state
tax differences between an S corporation and an LLC. Unlike the
IRS, California taxes an S corporation's net earnings at 1.5%, with
an $800 annual minimum. On the other hand, LLCs pay a flat $800
annual tax, plus a fee based on the company's gross income less
cost of goods sold. There is no fee if gross income is less than
$250,000. The fee is $900 if gross income is less than $500,000,
$2,500 if less than $1 million, $6,000 if less than $5 million,
and $11,790 if income exceeds $5 million. Your accountant can help
you determine the direction and extent to which this factor will
affect your business.
Select a name for the
entity. I would also urge you to consider picking alternate
choices, in case the name is rejected by the Secretary of State.
This can happen where the Secretary of State's office feels
the name you select is too similar to the name of an existing
entity. If a web presence is significant to your business model,
confirm the availability of your desired web address.
If you want to use a
corporation, confer with your accountant on the advisability
of taxing the corporation under Subchapter S of the Internal
Consider who should own
the stock or LLC interests, and in what percentages.
If you use a corporation,
decide who will fill the offices of President, Secretary, Treasurer,
and any other positions you want. The same person can hold any
or all of these offices. Also, decide who will sit on the Board
of Directors. You need at least as many directors as there are
shareholders, unless you have at least three directors. If you
use an LLC, decide whether all members will be managers, or
less than all.