Choice of Entity
Options
In Colorado, a new business typically takes the form of a corporation or limited liability corporation (LLC) or, possibly, a limited liability partnership. There are several other options: sole proprietorship, (general) partnership, limited partnership, and limited liability limited partnership. This dicussion focuses on Corporations and LLCs.
Non-Tax Considerations in Choice of Entity
Capitalization
Investment capital for a corporations or LLCs is usually raised by transferring property to the entity in return for stock in the corporation or “units” or interests in the LLC. Once the company is up and running it may require additional investment capital to operate until it becomes profitable. Even after it is profitable, it may require additional capital to grow big enough to be sold or merged. C corporations are ideal for raising investment capital at any stage of the process. S corporations are less flexible due to restrictions in the number and type of shareholders allowed to invest.
Many or most businesses operate and grow from their retained earnings. These are the profits left in the business after salaries and dividends or distributions are paid. If you plan to grow your business with retained earnings an S-Corporation or LLC may be a suitable choice of entity.
If you are starting a company that will be raising capital from a private equity group (PEG), a C corporation is preferred. This structure provides limited liability to shareholders and allows great flexibility in stock configurations. The exit strategy of many PEGs is to make an initial public offering (IPO) and the C corporation is ideal for this purpose. Also, the issue of double taxation is often not an issue for many younger companies which do not anticipate any profits for the first several years of operation.
Owner Liability
Corporations and LLCs provide limited liability to their owners. Absent fraud or negligence, the liability of a shareholder in a corporation or a member of an LLC is limited to his or her capital contribution to the entity. When LLCs first became popular, there was some question whether LLC members would truly enjoy the same level of limited liability as shareholders in a corporation. That is no longer in doubt. However, in Colorado, single member LLCs, do not provide the same level or protection and are to be avoided, as are multi-member LLCs where only one member is active in management and has any financial risk.
Flexibility of Ownership Interests
C corporations and LLCs are highly flexible in terms of customizing the rights and obligations of shareholders. Similarly, there are no restrictions on the number or type of owners in a C corporation or an LLC. For example, a foreign corporation can be a shareholder in a C corporation or LLC.
S corporations, on the other hand, cannot vary the rights and obligations of their shareholders. Also, generally, only individuals or other S corporations can be shareholders in an S corporation.
Transferability of Ownership Interest
Shares in publicly held corporations are easier to transfer than interests in closely held LLCs or corporations. This is due both to securities laws, which restrict the sale of interests in privately held companies, and because there is generally less demand for such interests. This issue may or may not be a relevant to the closely-held business owner, where control of the business outweighs other factors.
Rights of Creditors Against Owners
Creditors’ rights against a shareholder of a corporation are far stronger than against a member in an LLC. A creditor can generally seize the shares of a shareholder and either sell them or step into his or her shoes as a co-owner of the corporation. This may have significant adverse consequences to the corporation if, for example, the creditor gains a controlling share in the company or voids the S corporation status. By contrast, a creditor to an LLC member is limited to obtaining a charging order, which allows the creditor to receive distributions, if any, from the LLC. However, the creditor may not to vote or otherwise act as a member or manager of the LLC. It cannot force the LLC to issue any distributions or even to produce financial records. The creditor will also be responsible for paying taxes on his interest in the LLC. For these and other reasons, charging orders are not attractive to many creditors.
Single-member Colorado LLCs do not enjoy the same level of protection against creditors. Foreclosure by a creditor against the single member voids the member’s status as a member. The creditor can then appoint itself as the sole member and elect a manager, effectively taking over control of the LLC. This is another reason why single-member LLCs are not advisable.
Conversion of the Entity Type
LLCs are occasionally converted into corporations for purposes of raising capital, for example. This can be accomplished quickly and easily without any tax effects. Corporations sometimes seek to become LLCs to take advantage of the more flexible management structure or for other reasons. However, when a C corporation converts to an LLC, it is treated as distributing all of its assets. This is a taxable event unless the LLC opts to continue to be taxed as a C corporation. An S corporation converting to an LLC will incur fewer tax effects.
Ease/Cost of Formation. The benefits of forming and maintaining the formalities of a corporation or LLC, including limited liability to the owners and the ability to raise capital, far outweigh any costs. Corporations are formed by filing Articles of Incorporation with the Secretary of State. LLCs are formed by filing Articles of Organization. These costs are minimal. Corporations are governed by bylaws and LLCs are governed by an operating agreement. These documents are critical to the proper operation of the company. They should be professionally drafted by competent legal counsel. [Link to bylaws and operating agreements page?]
Control and Privacy
Control of a company is more a function of the company’s size and capital needs than a choice of entity issue. Owners of companies seeking to grow with private equity group money or by going public obviously often sacrifice control for capital. Owners of closely held companies, whether S Corporations or LLCs, usually maintain control for the life of the company, or until the owner sells the company or passes it on to his or her family.
The same can be said for privacy. Neither the Articles of Incorporation for a corporation nor the Articles of Organization for an LLC require that any member or manager be named. Thus, it is possible to form a Colorado corporation or LLC without disclosing who owns or manages it.
Contact Denver Business Lawyers for assistance.