Entities Part 2: LLCs, S-Corps and B-Corps

In my last post I gave an intro to business entities and discussed sole proprietorships / partnerships and Corporations. In this post I will describe LLCs, the alternative to Corporations, as well as S-Corp and B-Corp, which are actually “upgrades” that apply to both Corporations and LLCs.

Note: Please don’t try this at home. These issues are complex and should be addressed in a discussion with your lawyer. I provide this article for background and educational purposes only – not as a substitute for legal advice, so please don’t make a choice and then use a legal forms website to create your business documents. In the last month I’ve had three different projects that involved undoing damage done by legal forms from a website that did not correctly apply Massachusetts law or failed to give some basic advice that would have headed off problems later. As usual, some of the finer points here are specific to Massachusetts. Please consult a lawyer in your jurisdiction for help with business entity selection or any other issues.

LLCs: A more flexible approach

The LLC is a newer form of business entity. So new that many states did not even adopt it until the 90’s. Like a corporation, an LLC is a fake person. However, the rules governing the LLC’s operations are more flexible than those governing a corporation. An LLC may be managed by a board and officers, like a corporation, or by a designated manager or committee of managers, or by its owners (the “members” of the company). An LLC may choose the method of taxation that results in the lowest bills: pass-through, Corporate or S-Corp. An LLC is not required to make the same yearly filings as a corporation or to follow the same meeting formalities.

However, as with corporations, it is important to observe those formalities that remain in place in order to preserve the corporate veil. A well crafted LLC’s veil is in some ways superior to that of a corporation, in that it can work both ways: in many circumstances a creditor with a judgment against an LLC member may not seize the member’s interest in the LLC but may only receive “charging orders,” which are akin to wage garnishment but apply to owner profits.

The members of the LLC must decide on how the company will run, and also on other important matters such as whether and how new members will be admitted and what will happen if a member wishes to leave, dies or becomes unable or unavailable to perform duties for the company, and how a manager is chosen. These decisions are written into the LLC operating agreement. Therefore it is critical that the LLC members consult an attorney for advice on these options and to draft an operating agreement that meets the company’s needs.

The flexibility of an LLC makes it ideal for many smaller businesses. However, it has its downsides, some of which are:

  • Massachusetts LLC fees are higher than those for corporations. For a small corporation with a small number of shares that files its paperwork on time, fees can be as low as $275 for the initial filing and $125 for subsequent years. An LLC pays $500 per year in Massachusetts.
  • LLCs are usually less attractive to venture capital firms than corporations, primarily because VCs already have expertise in working with corporations and know how to structure their relationships with corporations to receive the benefits and assurances they want. Many VCs will require an LLC to convert to a corporation before they will invest.

Upgrade #1: S-Corp Tax Classification

I refer to S-Corp as an “upgrade” because it is not, in itself, a type of entity. You cannot go to the Secretary of the Commonwealth’s office and file papers to create an S-Corp. If you want an S-Corp, you must start with a C-Corp or an LLC and file IRS paperwork to elect S-Corp status.

The reason for S-Corp status is tax savings. An S-Corp avoids “double taxation.” Profits that are passed on to the shareholders as distributions are not taxed at the corporate level – only the shareholders pay taxes on the income. This can be a huge savings over C-Corp taxation. It can also be an upgrade over pass-through taxation, because any income disbursed to shareholders that is not wages for work done for the company is not subject to payroll taxes. (Note that if a shareholder works for the company, the shareholder must be paid a “reasonable” salary subject to payroll taxes before any non-payroll profits may be paid.)

The downside is that complex ownership structure are not eligible for S-Corp status. Only a privately held company with 100 or fewer shareholders, all of whom are in the same class, and all of whom are real people, is eligible for S-Corp status. This rules out most large companies, which are stuck with C-Corp status and taxes.

Upgrade #2: B-Corp Certification

The newest corporate “upgrade” is B-Corp. B-Corp is, in a legal sense, a modification of a company’s duties. The background is that in a traditional corporation, the duty of the company and its directors is to make money for its shareholders. This is a legally enforceable duty, and the directors may only insert “secondary” priorities, such as environmental sustainability, in a good-faith belief that doing so is likely to improve profits. A B-Corp is, by design or by statute, a company that prioritizes one or more “general public benefits” on the same level as profits – accepting a legal requirement that the company prioritize a public benefits program, place a director in charge of the benefits program, and making available a yearly report on the benefits program. “Benefit” is defined broadly by B-Lab, the organization behind the B-Corp system, as “material positive impact on society and the environment, taken as a whole, as assessed against a third-party standard, from the business and operations of a benefit corporation.”

B-Corp status can be beneficial for a number of reasons. For company owners with a strong desire to create community benefits and connections, the B-Corp system and B-Lab provide not just an opportunity to pursue public benefits but also a framework, incentives to monitoring and self-discipline, and methods of evaluating a benefits program and its outcomes. Some companies are now using the yearly report as a marketing tool and goodwill generator, such as this report from King Arthur Flour.

B-Corp status is available to any company regardless of entity type, but in Massachusetts the entity selection determines the steps to certification.

That wraps up this two part article. There are other business entity types available, such as limited partnerships and LLPs, that are less common and more specialized, but not of interest to most new businesses.

Upcoming Event: Business Law Primer in Cambridge, Weds., Jan. 13

On Wednesday, 1/13 at 6:00 PM I will be giving a presentation on business law for startups in Central Square. The location is the first floor of Workbar, 45 Prospect St. (a block from the Red Line stop). Workbar members and nonmembers welcome.

I will cover the most common topics my startup business clients ask about, including pros and cons of different business entity types (LLC, S-Corp, Partnership, etc.), how to work with (or as) an independent contractor and how intellectual property assets are identified, categorized and protected.

Registration is free. Please register at the Eventbrite page here so we can get a head count.