One of the most critical decisions for any new business is choosing the right business entity. This decision can have far-reaching implications, and if not given careful consideration, it can be the difference between a business that reaches its full potential and a business that flounders, crashes, and burns. This decision can affect everything from liability, taxation, raising capital, and day-to-day operations. However, this is complex territory to navigate alone. We are more than happy to summarize the key advantages and disadvantages of the three most common business structures, C corporations, S corporations, and LLCs. 

Here are some of the most important factors to consider to ensure you know how to choose the right business structure when starting your business.

S Corp vs. C Corp vs. LLC

The main difference in S Corp vs. C Corp vs. LLC is rooted in their tax structures, ownership limitations, and administrative burdens. LLCs and S-Corps are both known for their pass-through taxation, which avoids the double taxation issue that C-Corps face. However, S-Corps have strict limits on the number and type of shareholders, whereas C-Corps and LLCs offer more flexibility in ownership, making them better suited for different business goals and growth strategies. This is a critical factor when choosing which structure is right for you, as it will determine how you can raise capital and distribute profits.

Choosing the Right Business Entity: S Corp vs. C Corp vs. LLC

When you are choosing the right business entity, you generally have 3 different options: an LLC, an S Corporation, or a C Corporation. Deciding between each can be daunting, and you’re probably wondering, What type of business entity should I choose? We’re here to help. 

Choosing the right business structure means understanding your unique business needs, the pros and cons when debating an S-Corp vs. C-Corp vs. LLC, and which one best aligns with your goals and vision. So, let’s get into it, starting with the pros and cons of an S-Corp!

Pros and Cons of an S Corporation (S-Corp)

The first type of entity you will encounter when trying to determine how to choose the right business structure is an S Corporation, also called an S-Corp. This type of structure offers some key advantages that you might want to capitalize on. Here are the pros of an S-Corp structure:

1. Pass-Through Taxation: Income, losses, deductions, and credits flow directly to shareholders, avoiding the double taxation seen with C-Corps.
2. Liability Protection: Like a C-Corp, an S-Corp generally shields shareholders from personal liability with very limited exceptions.
3. Tax Benefits: Shareholders can claim business losses on personal tax returns, potentially lowering overall tax liability. Shareholders can also, after paying themselves a reasonable salary, take additional profits from the company in the form of distributions, for which there is no self-employment tax imposed for Social Security or Medicare, resulting in cost savings for the shareholders (ie, 15.3% tax savings at the federal level).

It’s important to note that this type of business entity also has drawbacks that you should consider to ensure they are worth the reward. Here are the cons of an S-Corp structure:

1. Shareholder Limitations: S-Corps are limited to 100 shareholders, and all must be U.S. citizens or residents. In addition, with very limited exceptions, an entity cannot be an owner of an S-Corp. For example, a C-Corp or an LLC with more than one member could never be a shareholder in an S-Corp. 
2. Stock and Distribution Restrictions: Only one class of stock is allowed, which can limit flexibility in fundraising. In addition, the shareholders must receive any distributions from the S-Corp in the exact pro rata amounts of their percentage ownership of shares in the company. Therefore, if the ownership percentages were 50%-30%-20%, those three shareholders could only receive distributions from the company in those precise percentage amounts. This rigidity makes an S-Corp more difficult to use with businesses where the owners desire some flexibility as to how they pay themselves. 
3. Increased IRS Scrutiny: The IRS often closely examines S-Corps to ensure compliance with their rigorous distribution and salary requirements, and failure to comply with those requirements can lead to the termination of a company’s S election, which can have adverse tax consequences.

Pros and Cons of a C Corporation (“C-Corp”)

Similarly, the second structure you will encounter when weighing your options and choosing the right business entity is the C Corporation, also called a “C-Corp.” This type of structure has some benefits that could be appealing depending on your situation. 

The pros of a C-Corp structure are as follows:

1. Unlimited Growth Potential: C-Corps can issue multiple classes of stock and an unlimited number of shares, making them ideal for attracting investors and for a business with an objective of eventually going public.
2. Separate Legal Entity: Shareholders enjoy limited liability, meaning personal assets are generally protected, save for very limited exceptions.
3. Tax Advantaged for Reinvestment: Profits retained within the corporation are taxed at the corporate rate, which can be advantageous for growth-focused businesses looking to reinvest those profits in the business or ancillary businesses.
4. Easier to Raise Capital: C-Corps are the preferred structure for venture capitalists and other savvy institutional investors due to point number 1 above, as well as the various limitations that an S-Corp or LLC has with regard to raising capital at a heightened level or their suitability for serving as a vehicle for going public.

Still, there are some drawbacks that you should consider. Here are some of the most pertinent cons of using a C-Corp structure:

1. Double Taxation: Profits are taxed at the corporate level, and dividends distributed to shareholders are taxed again on personal returns. Therefore, many business owners do not find C-Corps suitable if the chief objective of the business is to distribute profits to owners rather than the owners receiving all compensation via salary payments. 
2. Complexity and Costs: Formation and compliance requirements, such as annual filings and board meetings, can be time-consuming and expensive.
3. Inflexibility: C-Corps are highly regulated, and changes to the business structure require formal procedures.

Pros and Cons of a Limited Liability Company (LLC)

The final choice that’s important to go over that you will surely encounter when choosing the right business structure is a Limited Liability Company, or an LLC. Here are some advantages of an LLC that are important for you to know:

1. Greatest Flexibility: LLCs can choose to be taxed as a sole proprietorship, partnership, or corporation, offering significant flexibility. A multi-member LLC taxed as a partnership has the discretion to pay its members (ie, owners of the LLC) virtually any way it wishes, allowing for the greatest amount of flexibility. 
2. Limited Liability: Members’ personal assets are generally protected from the company’s liabilities with very limited exceptions.
3. Fewer Formalities: LLCs are not required to hold annual meetings or have a board of directors, and thus legal compliance is simpler and less costly than with other entities. 
4. Pass-Through Taxation: Income and losses flow directly to members, avoiding the double taxation issue seen with C-Corps.

Like the other types of business structures, an LLC is not without its drawbacks. Here are some important cons of an LLC you should be aware of:

1. Self-Employment Taxes: Members must pay self-employment taxes on their share of the profits, which can be higher than corporate taxes.
2. Limited Growth Potential: LLCs are, by their nature and statutory law, designed to suit smaller business enterprises, and thus investors often prefer corporations, especially if the company plans to raise significant capital or go public.
3. Varying State Laws: Rules governing LLCs differ by state, which can add complexity for businesses operating in multiple jurisdictions.

Key Considerations for Choosing the Right Business Entity

When deciding on the right structure, entrepreneurs should consider several factors to make a strategic and informed decision that positions them for future prosperity. Here are 6 key considerations that will determine how to choose the right business structure:

1. Growth Plans: If your goal is to attract venture capital or go public, a C-Corp might be the best choice.
2. Tax Implications: Evaluate how the entity will impact your personal and business taxes. S-Corps and LLCs offer pass-through taxation, while C-Corps have corporate taxes. An S-Corp allows for tax savings for its owners by avoiding payment of self-employment tax on distributions, but also has rigorous requirements for who can hold S-Corp stock and how distributions may be paid. 
3. Liability Protection: All three entities provide limited liability, but compliance is crucial to maintain this protection.
4. Cost and Complexity: LLCs are generally easier and cheaper to form and maintain, while corporations require more formalities.
5. Number and Type of Owners: S-Corps have strict shareholder requirements, while C-Corps and LLCs offer more flexibility.
6. Long-Term Vision: Consider the scalability of your business structure, especially if you plan to expand nationally or internationally.

Set Your Business Up for Success from the Start with Expert Guidance in Choosing the Right Business Entity.

Choosing the right business entity is a critical decision that can dictate its success, so it’s not one to take lightly. That’s why understanding how to choose the right business structure is so crucial – this simple decision you make at the start can, in some ways, determine its fate. While each structure offers distinct benefits, it’s important to assess your business goals, industry, and future plans before making a choice. A professional can help you decide what’s best for you. 

Consulting with an experienced attorney, like those at Petersen + Landis, P.C., can ensure your business is set up for success from the start. Contact us today to learn how we can help.

Disclaimer: This blog post is for informational purposes only, and is not intended to be, nor shall it be considered, legal advice in any way. The topics herein are addressed in a general manner, whereas anyone seeking legal advice should consult with any attorney personally to address the specific facts and circumstances surrounding one’s personal legal objectives and needs. 

The United States Attorney’s Office for the Southern District of New York announced that Manhattan tax attorney Harold Levine and Florida certified public account Ronald Katz were charged in Manhattan federal court in an eight-count Indictment with engaging in a multi-year tax evasion scheme involving the diversion of millions of dollars of fees from a Manhattan law firm, and the failure to report that fee income to the IRS.   

U.S. Attorney for the Southern District of New York Preet Bharara said in the release: “As tax professionals and partners at professional firms, both Harold Levine and Ronald Katz knew better.  But as alleged, they engaged in a multi-year scheme to divert and evade taxes on millions of dollars of fee income.”

The Indictment alleged that Levine, a tax attorney and former head of the tax department at a Manhattan law firm, participated in a scheme with Katz to divert from the law firm over $3 million in fee income from tax shelter and related transactions that Levine worked on while at the firm.  In addition, per the Indictment Levine failed to report that fee income to the IRS on his personal tax returns, and Katz received and failed to report to the IRS over $1.2 million in fee income.     

The Indictment alleged that as part of the fee diversion scheme, Levine caused tax shelter fees paid by a firm client to be routed to a partnership entity he co-owned with Katz and thereafter used approximately $500,000 to purchase a home in Levittown, New York, then took improper tax deductions on the home as rental property. 

The Indictment also alleged that Levine made false statements about the purported rental property when questioned by IRS agents concerning his involvement in certain tax shelter transactions and the fees received for those transactions, and urged a third party to make false statements to the IRS about that property. 

Levine and Katz are scheduled to be arraigned on October 31^st.

Jeff Petersen is an attorney licensed in California and Illinois representing clients in a wide variety of regulatory matters. He can be reached in California at 858.792.3666 and in Illinois at 312.583.7488.

A recent case from the Delaware Chancery Court has cast doubt on the validity of bylaws containing supermajority voting requirements on items where Delaware’s General Corporation Law (“DGCL”) contains a specific voting threshold.

Frechter v. Zier, C.A. No. 12038-VCG (Del. Ch. Ct. Jan. 24, 2017)

In Frechter v. Zier, C.A. No. 12038-VCG (Del. Ch. Ct. Jan. 24, 2017), a shareholder of Nutrisystem, Inc. sued the company and its directors for declaratory judgment to invalidate a provision in Nutrisystem’s bylaws requiring a vote of two-thirds of the company’s shares before a director could be removed from the board.

The plaintiff relied on Section 141(k) of the DGCL, which provides that “[a]ny director or the entire board of directors may be removed, with or without cause, by the holders of a majority of the shares then entitled to vote at an election of directors” (with certain exceptions that were not applicable). Defendants argued that the board was empowered to adopt the bylaw pursuant to DGCL Sections 109(b) and 216 of the DGCL —which provide for, respectively, the adoption of bylaws not inconsistent with law or the certificate of incorporation, or bylaws specifying the required vote for a transaction subject to other provisions of the DGCL.

Chancery Court Chancellor & Plaintiff Agree

The Chancery Court Chancellor agreed with plaintiff, concluding that Section 141(k) prohibits any bylaw requiring a supermajority vote for director removal because any such requirement would be inconsistent with “the plain language of the statute.”  The Chancellor added that any contrary interpretation would render Section 141(k) “an effective nullity.”

This opinion has significant implications for any bylaw provision requiring supermajority shareholder votes for any item for which the DGCL provides a specific voting threshold. Corporations should consider removing any such supermajority voting requirements from their bylaws and instead placing them in the certificate of incorporation.

Placement of supermajority provisions in the certificate of incorporation is preferable because Section 102(b)(4) of the DGCL permits a corporation to include in its certificate of incorporation “

Provisions requiring for any corporate action, the vote of a larger portion of the stock or of any class or series thereof, or of any other securities having voting power . . . than is required by this chapter.” The DGCL has no similar provision with respect to bylaws.