Why Should You Form a Corporate Entity When Starting a New Business? TLF Attorney Shalini Natesan Shares Some Insight

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What are the Benefits of Forming a Corporate Entity?

There are many benefits of forming a corporate entity when starting a new business. First and foremost is protection from liability. If set up correctly, forming a business entity such as a corporation or limited liability company (LLC) will protect you and your fellow members or shareholders, if any, from personal liability, subject to some exceptions. Further, if rules of corporate governance are followed, future disputes may be avoided. There may even be some tax benefits.

What are the most popular types of business entities?

The most popular types of business entities are the corporation, limited liability company (LLC), limited liability partnership and partnership. We will focus on corporations and LLCs here.

Corporations and LLCs: Personal Liability Protection

Corporations and LLCs generally offer personal liability protection not afforded by sole proprietorships and partnerships. Meaning, any liabilities incurred by the corporation or LLC would usually be limited to the assets of the business, and would not subject the members of the LLC or shareholders of the corporation to personal liability. This is subject to exceptions and limitations where the members or shareholders engage in misconduct, intentional bad acts or other negligent acts or are required by vendors, suppliers or lenders to personally guarantee the business entity’s obligations.

Corporations generally provide protection for their shareholders’ personal assets. Corporations often incorporate in the State of Delaware, as Delaware corporation laws are more favorable to the corporation than in most other states, including New York. The Internal Revenue Code provides for differing taxation for two types of corporations – S-corporations and C-corporations. S-corporations, or, small business corporations, are more common for small businesses. This entity eliminates the double taxation to which C-corporations are subject. S-corporation profits pass through to shareholders untaxed at the corporate level, providing for only one tax event, while the shareholders retain asset protection. Limitations of the S-Corporation include only being able to offer one class of stock, having a maximum number of 100 shareholders and do not include as shareholders any non-resident alien. It should be noted that while only one class of stock is permitted in S-corporations, there can be voting and non-voting stock issued.

On the other hand, C-corporations are more common for larger businesses, and such businesses are almost all filed as Delaware corporations.  While also providing personal asset protection for its shareholders, a C-corporation allows unlimited shareholders, allows the public to buy shares of the corporation via an initial public offering, and is permitted to have more than one class of stock. However, a major drawback of C-corporations is the double taxation that occurs as the C-corporation pays a corporate tax on profits and distributions are also taxed to the shareholders. Your accountant is best suited to assess which entity to form, either an S-corporation or a C-corporation. In New York, the process for setting up either is straight-forward, less expensive and less fraught with potential pitfalls that the process of forming an LLC.  The corporation must file a certificate of incorporation with the Department of State, which includes the appointment of a registered agent. After formation, proper corporate governance requires that corporate bylaws be prepared and adopted by a vote of the shareholders with the shareholders then electing directors, and the directors electing the officers to run the day-to-day affairs of the corporation. After formation, the corporation should hold annual shareholder and board meetings, keep meeting minutes, file a biennial statement and ensure all corporate taxes are paid in a timely manner. Once formed, the determination to elect either S-corporation status or C-corporation status is made by means of a filing with the IRS within 75 days of formation. Your accountant should assist you with this election as it has lasting tax consequences.

From a governance standpoint, LLCs are ideal for small to medium-sized businesses. While initially more expensive and more requirement laden, once formed, there are fewer operating formalities going forward when compared to corporations. The additional expense associated with the formation of an LLC triggered by the public advertising required with LLCs typically equates to more initial expense and regulatory obligations than those for corporations. Once formed, LLC’s provide the same liability protection as corporations, with more flexibility in running the business, as LLC are not required to have a board of directors, can be member-managed or manager-managed, are allowed an unlimited number of owners and, unlike an S-corporation, can have differing levels of ownership. Similar to an S-corporation, the LLC can elect to have the LLC treated as a pass-through entity, whereby earnings of the LLC are passed to owner(s) without paying a tax at the entity level first. The process for filing an LLC requires the filing of Articles of Organization with the NYS Department of State, advertising the formation of the LLC and adopting an Operating Agreement. The publication requirement for LLCs and the subsequent obligation to file proof of publication and affidavit of publication is one of two areas of risk in the formation of an LLC in New York. The second area of risk in the formation of an LLC requires that an Operating Agreement be adopted within 90 days of formation. The Operating Agreement details the members, their ownership percentages, how the LLC is to be managed as well as other operational rules that the LLC must follow. If the LLC fails to file proof of advertising or fails to adopt an Operating Agreement within the time required, the entity may not be a valid entity, thereby exposing the owners to personal liability where protection from personal liability was the goal. A further tricky nuance of LLCs in New York is that even if there is only one member of the LLC, the LLC must have a written Operating Agreement. The manager of the LLC should be cognizant of the requirements as listed in its Operating Agreement and follow them closely so there is no appearance of impropriety.

Both corporations and LLCs should follow corporate formalities and ensure separation is maintained between the company and its owners. When there is no separation and it can be shown that the owners are actually operating the company as if there is no corporation or LLC, a court could find that company is really an “alter ego” of its owners and “pierce the corporate veil”. When this occurs, courts can decide that there is no liability protection and impose personal liability on the owners.

Written By: TLF Business Attorney, Shalini Natesan, Senior Associate at TLF

The Towne Law Firm is ready to help you with all of your business needs. Contact us if you are interested in forming a business entity. TLF covers a multitude of business-related legal issues and matters, including but not limited to:

• Drafting the necessary documents for all business and corporate formations and transactions
• Creating partnership and joint venture arrangements
• Remaining in compliance with all applicable Federal and State laws necessary to enjoy the benefits and protections of the particular type of business organization you have chosen
• Creating subsidiary entities to handle specific areas of your business
• Protecting your investments in research and development, technology and human capital by drafting enforceable employment agreements, confidentiality agreements and covenants not to compete
• Learn more about how TLF’s attorneys can represent your business.