Starting or owning a business demands much more than having a great idea for a product or service and a company name. There are several important decisions and steps that need to be taken to formally and legally establish a new business entity. Our blog series on Starting a Business begins with the key topic of Entity Selection and Creation, and what considerations should be made when deciding the entity type and the critical implications of those decisions.
When starting a business, registering a formal business entity with the Secretary of State is an important step. Selecting the right entity is vital, as the entity you choose will impact your taxes, liability, compliance requirements, and finances. Generally speaking, businesses can be formed as sole proprietorships, partnerships, limited liability companies (LLCs), and corporations. The two primary business entity structures selected by entrepreneurs today are LLCs and corporations. In this blog, we’ll explore the similarities and important differences between these two business structures.
Corporations
Between LLCs and Corporations, Corporations are the more complex and formal business entity option. Registration and compliance for corporations involves a range of state and federal operational requirements. In both North Carolina and South Carolina, these include:
- Filing Articles of Incorporation. An incorporator must register the business by filing Articles of Incorporation with the Secretary of State. These Articles must include, among other things, the total number and classes of shares the corporation will have and be able to issue to shareholders.
- Appointing and Adopting Bylaws. Corporations are legally required to adopt Bylaws that outline the internal rules and procedures for operating the business. The rules include setting the term and positions for board members and corporate officers. The rules also include procedures for shareholder and board meetings. It is critical that Corporations follow the rules they set forth in their Bylaws meticulously, as consistently neglecting corporate procedures is one of the few things that can lead shareholders to lose their liability protection.
- Filing an Annual Report. Corporations must file an annual report with the Secretary of State that states general information about the business. In North Carolina, this report must be filed by April 15th of each year. In South Carolina, the due date is March 15th.
- Conducting Annual and Special Meetings. Corporations are required to hold annual meetings for shareholders and directors and keep minutes of these meetings as part of their official records. They must also hold special meetings prior to taking significant corporate actions as determined in the Bylaws. For example, shareholders must meet to approve of something like the purchase of another entity. The Bylaws can waive the requirement for in-person meetings and authorize the corporation to take action pursuant to the written consent of the requisite amount of directors and shareholders.
Corporate Tax Options
Corporations can either be taxed as C-Corporations under the Internal Revenue Code (IRC) Subchapter C or as S-Corporations under IRC Subchapter S. Both have distinct implications for how profits are taxed and distributed.
- C-Corporation. This is the default tax election for corporations. In a C-Corporation, profits are taxed first at the corporate level when earned. Then the remaining profits are taxed again at the individual level when they are distributed to shareholders as dividends. This “double taxation” can be a significant disadvantage but can be mitigated by the ability to retain earnings within the company for growth and expansion (in an LLC, members are generally taxed on all company income whether or not the company makes a distribution of profits).
- S-Corporation.A corporation can opt out of this default and elect to be taxed as an S-Corporation by filing Form 2553 with the IRS. This election allows the corporation to avoid double taxation. Instead, profits and losses pass through to the shareholders’ personal tax returns, and taxes are paid at the individual level. S-Corporations have specific eligibility criteria, so this election is not available to all corporations. Corporations taxed as S-Corps are not allowed to have more than 100 shareholders, no foreign shareholders, and cannot have entity shareholders.
LLCs
LLCs offer a flexible and straightforward option for business owners, providing numerous advantages in terms of management and tax treatment. Registration and compliance for LLCs is simpler than that required for corporations, and the company has broad freedom to determine what practices and procedures it will establish. Still, there are certain steps that LLCs must follow. These include:
- Filing Articles of Organization. Articles of Organization are the LLC counterparts to a corporation’s Articles of Incorporation. LLCs are required to file their Articles of Organization with the Secretary of State. The Articles only have to state the name of the company, the name and address of the organizer (the individual filing the business), and the name and address of the registered agent. A company may provide additional information about the company, for example, the names and address of the members, but it is not required to do so.
- Filing Annual Reports: LLCs must file an annual report with the Secretary of State. In North Carolina, annual reports are due April 15th and in South Carolina, these are due March 15th. This report typically includes basic information about the business, such as the names and address of its members.
- Adopt an Operating Agreement (not required but highly recommended): The Operating Agreement is a governing document and is the LLC counterpart to a corporation’s Bylaws. North Carolina and South Carolina have both adopted laws that set default rules governing LLCs that govern in the absence of operating agreements, but any written operating agreement will generally supersede these default rules in all but a few cases. Because the statute provides governance rules, LLCs are not required to adopt Operating Agreements the same way corporations are required to adopt Bylaws. However, we recommend businesses adopt Operating Agreements if the owners prefer different rules to the default rules established by statute and because banks and other professional relationships dealing with the LLC often require this document.
When drafting an Operating Agreement, it is important that the LLC adopt rules and procedures it actually intends to follow. As is the case with Corporations following its Bylaws, failing to adhere to the documented procedures compromises the liability protection provided by the LLC entity selection.
LLC Tax Options
By default, a single-member LLC is taxed as a sole proprietorship, and a multi-member LLC is taxed as a partnership. However, an LLC can also elect to be taxed as an S-Corporation, providing potential tax savings by allowing owners to pay themselves a salary and receive distributions that are not subject to self-employment tax. Notably, in each of these cases, the company’s profits are not taxed at the entity level, avoiding double taxation.
- Sole Proprietor Taxation. A single-member LLC is treated as a “disregarded entity” for tax purposes. This means that the LLC’s income and expenses are reported on the owner’s personal tax return. The owner will then pay self-employment taxes on the net income from the business, which includes Social Security and Medicare taxes.
- Partnership Taxation. For multi-member LLCs, the default tax treatment is as a partnership. The LLC files an informational tax return reporting its income (but does not pay any taxes on these profits). Each member then receives an IRS Schedule K-1 detailing the member’s percentage of the income, deductions, and credit from the LLC. Each member then reports this information on their individual tax returns and pays taxes based on their respective shares.
- S-Corp Taxation. Like corporations,both single-member and multi-member LLCs can opt out of the defaults described above and can instead elect to be taxed as an S-Corporation. This election allows the LLC to avoid double taxation while potentially reducing self-employment taxes. Owners can pay themselves a reasonable salary, subject to payroll taxes, and take the remaining profits as distributions, which are not subject to self-employment tax. However, there are strict eligibility requirements and additional administrative responsibilities.
LLC V. Corporation
Apart from registration, compliance, and tax matters, there are other less tangible factors to consider when determining whether to create an LLC or corporation. For example, a company that intends to raise significant capital through investors might choose to be a corporation because sophisticated and larger investors prefer to invest with corporations (for a number of reasons). However, a company that is not primarily concerned with raising capital through investments might value an LLC’s ease of maintenance over investor-attraction.
Whether you choose an LLC or a corporation depends on various factors, including your business goals, tax considerations, and operational plans. At Skufca Law, our experienced attorneys are dedicated to guiding you through the process of selecting the entity that best meets your unique needs. From initial consultation to registering your business entity with the Secretary of State, we are here to ensure a smooth and efficient process. Contact Skufca Law at (704) 376-3030 today to assist you with your business formation.
Next up in our Starting a Business series, we will discuss establishing your Corporate Governance including assigning a board and officers, preparing bylaws, operating agreements and more.
| LLC | Corporation | |
| Registration and Annual Maintenance | Articles of Organization Annual Report | Articles of Incorporation Annual Report Bylaws Board of Directors Annual Meeting of the Board and Shareholders Special Meetings of Board and Shareholders |
| Taxes | Pass-Through (Sole Proprietorship, Partnership, or S-Corp) | Double Tax Pass- Through (S-Corp) |
| Liability Protection | Limited liability | Limited Liability |
| Investors | Fine for angel investors but larger investors do not prefer | Venture capitalists and larger investors prefer |
| Flexibility | Owners can choose how they want the business to be managed and taxed. This includes options for manager-managed or member-managed structures. | Less flexibility in terms of management and distribution of profits compared to LLCs. |