Monday, May 21, 2012

Forming an S-Corporation (Sub-S Corp) and a Limited Liability Company (LLC) in New York Part 2

 In Part II of our series on choosing a corporate entity, we continue to answer many of your questions about which entity is best for you.


How long does it take to form an S Corporation?
For about $200 in fees, your corporation will be in existence within 24 hours.  However, you normally have to wait a couple of days to receive the necessary documents in the mail to prove that your corporation has been formed.  This may be necessary for opening a bank account.
How long does it take to form an LLC?
You can form an LLC within 24 hours.  However, you normally have to wait a couple of days to receive the necessary documents in the mail to prove that your LLC has been formed.  This may be necessary for opening a bank account.  Many banks will also require you to show an operating agreement (see discussion below) before they will open an account for your LLC.  The publication requirement has to be completed within 120 days of formation. Notwithstanding, you can start doing business with your LLC as soon as it is born.  If you fail to fulfill the publication requirement, your business loses the authority to conduct business in New York with the expiration of the 120-day period.

Does an S Corporation offer limited liability to Shareholders?
As long as you keep up with all corporate formalities, a corporation offers almost complete limited liability.  Shareholders only risk losing the initial investment in the corporation.  Creditors normally cannot reach the shareholder’s personal assets.
Does an LLC offer limited liability to its Members?
Yes, the LLC is liable on all business debts, not the members personally.  If the business goes under, creditors of the business cannot reach the personal assets of the members.

What formalities are required to maintain an S Corporation?
Among other formalities, S corporations require annual shareholder and director meetings.  Important decisions by the S corporation must be documented in “minutes” or “written resolutions” of shareholders or directors’ meetings.
Formalities are important to preserve the “limited liability shield” of the S corporation.
What formalities are required to maintain an LLC?
LLCs require less ongoing paperwork than S corporations; however, unless the operating agreement (see below) of the LLC states otherwise, the LLC must also hold annual member meetings.

Can an S Corporation issue Shares with different economic rights?
No.  All shares of the S corporation must have the same economic rights to profits, distributions and liquidation of assets.  In other words, a shareholder who owns 50% of the shares of the S corporation can only receive 50% of the distributions of the S corporation.
Can an LLC have Membership Interests with different economic rights?
A special feature of an LLC is that the members can agree to share profits and losses in proportions different from their membership interests.  In other words, the members could agree that 100% of the profits of the LLC are to be distributed to one member for the first three years, despite the fact that that member owns only 50% of the LLC and normally should have received only 50% of the profits and losses.
But these so called “special allocations” have to follow quite complicated tax rules to make them permissible.  This adds a layer of complexity and extra cost to the management and accounting for the LLC.

Who manages an S Corporation?
A “board of directors” manages the affairs of the corporation through officers. Officers of a corporation are often named president, vice president, treasurer, secretary, chief operating officer and so forth.  Sometimes the law or the “bylaws” of a corporation provide that the shareholders have to approve certain actions by the corporation.  Bylaws are rules that govern the corporation.  When a corporation is formed, the initial directors approve the original bylaws of the corporation.
All three groups in the corporation, directors, shareholders, officers, can be the same person. In other words, if you form a corporation and are the only shareholder, you will also be the only director and may be several officers in one.
Who manages an LLC?
An LLC can be managed by its members or by appointed managers.  Unless the articles of organization of the LLC provides for management by managers, the LLC is managed by its members.

What is a Shareholders Agreement and do I need one?
Shareholders can enter into a shareholders’ agreement to regulate certain matters that come with their share ownership.  For example, unless you agree with your fellow shareholders in a shareholders agreement that the shares are not “freely transferable”, any shareholder would be able to sell his shares to a third person. Such person would then become a co-owner of the business.
Thus, unless you are the sole shareholder of your corporation, it is advisable to enter into a shareholders’ agreement.
What is an Operating Agreement and do I need one?
Members of an LLC (even a sole member of an LLC) must enter into a written operating agreement.
Similar to a shareholders’ agreement, an operating agreement regulates ownership of the LLC and the business affairs of the LLC. For example, you can put restrictions on the transferability of the membership interests.

Does the S Corporation pay Taxes?
Not on the federal level, but for exceptions in New York State and New York City, see note below.
A regular business corporation is a taxpayer separate from its shareholders.  The corporation pays taxes on its profits.  When the corporation distributes profits to the shareholders (called dividends), the shareholder have to pay tax again on such distribution.  This is called “double taxation.”  By electing S corporation status, S corporations avoid this double taxation.
Each individual S corporation shareholder will include her share of the S corporation’s income, loss and deductions on his or her individual state and federal tax return.  For this reason, an S corporation is also known as a "pass-through entity."
Does an LLC pay Taxes?
A one-member LLC is treated as a “disregarded entity.”  The only member reports income, losses and deductions of her LLC on her personal federal and state income tax return like a sole proprietor.
A multi- member LLC is normally treated as a partnership for tax purposes.  Just like a partnership, the LLC does not pay taxes, but files an informational return
Members report their share of the LLC's income, loss and deductions on their individual state and federal tax return.  For this reason, an LLC is also known as a "pass-through entity."

Can a Shareholder deduct Losses of the S Corporation?
Yes, a shareholder of an S corporation can deduct her share of the losses of the S corporation.  However, there are limits.  Compared to LLCs, S corporations allow for less loss deduction.
Can a Member deduct Losses of the LLC?
Yes, a member of an LLC can deduct his or her share of the losses of the LLC.

Do Shareholders have to pay Self-Employment Taxes on Money they receive from the S Corporation?
No.  However, shareholders of an S corporation who work for the business have to pay themselves a reasonable salary.  They are considered employees of the S corporation.  Consequently, the S corporation has to withhold federal and state taxes from their salary, pay unemployment insurance and its share of social security and Medicare payments.
There still may be savings over the self-employment tax due from members of an LLC. S corporations can pay out all profits above a reasonable salary as dividends to their shareholders.  There are no self-employment taxes or other employment taxes due on such payments.  In determining a "reasonable" salary, be aware of the audit risks involved.
Do Members have to pay Self-Employment Taxes on Money they receive from the LLC?
Members who are actively involved in the business of the LLC have to pay 15.3% self-employment taxes on the first $106,800 of their combined wages and net earnings, including the income allocated to them from the LLC.

Can a Shareholder be an employee of an S Corporation?
Yes, by default, anybody working actively in the S corporation is considered an employee; i.e. the corporation must do payroll for the employee: withhold federal and state taxes, pay its share of social security and Medicare, and pay unemployment insurance.  The corporation can deduct the cost as expenses.
Can a Member be an Employee of an LLC?
No.  A Member cannot be an employee of an LLC.  Even though a Member can actively work in the management of the LLC and receive so-called "guaranteed payments" similar to a salary, technically he or she would not be considered an employee.

Can an S Corporation choose a different Tax Status?
An S corporation can choose to abandon s corporation status and become a regular corporation again. There are limits and restrictions on how often the switch can be done.
Can an LLC choose a different Tax Status?
An LLC can choose to be taxed as a corporation or a partnership.

Can I raise money for the S Corporation from outside investors?
The S corporation can issue shares to investors in exchange for capital that can be used to grow the business.  Investors will become owners of the corporation, but can be excluded from management (if they agree).
Can I raise money for the LLC from outside investors?
The LLC can issue membership interests to investors in exchange for capital that can be used to grow the business.  Investors will become owners of the LLC, but can be excluded from management (if they agree).  For their own valid reasons, certain venture capitalists will require a corporation for their investment.

In Part III of the series we will sum up the pro and cons of each entity.  Feel free to contact us at LawInfo@CiminelliLaw.com if you have any questions about starting your business.

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