Selecting the right business form for a new business venture requires not only an understanding of the strengths and weaknesses inherent in each of the different business structures available, but also an understanding of complicated issues related to the expected financial growth and operational control of the new company.
As Part 1 of this article mentioned, most businesses operating in California fit into one of these four organizational business structures:
- sole proprietorships;
- corporations; and
This article (Part 2 of 2) will focus on the latter two: corporations and LLCs.
Corporations are perhaps the most well known and widely used type of business form. This makes sense because a corporation, as a business structure, has been around for a very long time. While there are different types of corporations (e.g., professional, public, non-profit, statutory close corporations, etc.), this article is aimed only at offering a broad overview regarding what a corporation actually is, and therefore this article will only discuss the two most common “types” of corporations: C corporations and S corporations.
For the most part, corporations are:
- formed by filing certain documents with the Secretary of State (e.g., Articles of Incorporation);
- perpetual in duration (don’t automatically terminate upon the death of a shareholder);
- governed by state law (including requiring compliance with certain corporate formalities relating to filing annual statements of information with the Secretary of State, holding director elections, keeping minutes of shareholder/director meetings, etc.);
- owned by shareholders;
- managed by a board of directors (who are elected by the shareholders);
- operated on a day-to-day basis by officers (e.g., President, CFO, Secretary, etc.) selected by the directors;
- governed by a shareholder/buy-sell agreement; and (most importantly)
- offer limited liability to the shareholders (i.e., shareholders’ assets are shielded from creditors of the corporation).
A lot of people are also confused regarding the difference between a “regular” (i.e., C) corporation and an S corporation. While the differences are vast, and can get quite complicated, for purposes of this article, all you need to know is that an S corporation is a tax designation offered under the federal tax code. An S corporation is, broadly speaking, a blend of the regular corporation and the more relaxed LLC (discussed below). S corporations must meet certain criteria (e.g., limitation on number of shareholders, residency requirements, etc.), and unlike C corporations, which are taxed as entities (with the corporation itself paying taxes on revenues, and the shareholders then paying taxes on distributions they receive), shareholders of S corporations are taxed like partnerships or members of LLCs—i.e., net revenues of the company are “passed through” as income to the members in proportion to the shares held regardless of whether or not the shareholders actually receive any distributions. [When to choose a C corporation or S corporation, or the specific tax and non-tax related requirements/options, are topics for another article.]
What matters most is that corporations are governed by directors, managed by officers, and provide the owners (the shareholders) with limited liability from the debts/obligations of the corporation.
Compared to corporations, LLCs are relatively new (as business organizations go), having been created just a few decades ago. Simply put, LLCs blend the simplicity and flexibility of the partnership with the limited liability of the corporation.
LLCs in California are governed by the California Revised Uniform Limited Liability Company Act, and are typically:
- formed by filing certain documents with the Secretary of State (e.g., Articles of Organization);
- governed by state law, including imposing certain default provisions, many of which can only be overridden by a written operating agreement between the members;
- owned by the members;
- managed by the members (although some LLCs are designated manager-managed, meaning that either only some of the members manage the day-to-day operations of the business, or that the members select non-member, professional managers to do so);
- operated on a day-to-day basis by the members (but not always, such as if the LLC is designated as a manager-managed LLC);
- governed by an operating agreement; and (most importantly)
- offer limited liability to the members (i.e., members’ assets are shielded from creditors of the LLC).
LLCs require fewer corporate formalities than do corporations (e.g., no elections required, no annual meetings required, no minutes required, and statements of information only due every two years rather than annually), and are considered more flexible. Again, as with corporations, there are distinct tax advantages and disadvantages that are beyond the scope of this article.
What matters most is that LLCs are simple, flexible, typically managed by the members themselves, and provide the members with limited liability from the debts/obligations of the LLC.