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.

What’s with all the letters? Corporate Entities, Part 1

Two weeks ago I gave a seminar in Cambridge on the three issues that startup business clients most often ask me about. These were entity selection, IP protection and use of independent contractors. I already covered independent contractors in a recent post, and now I’m following up with entity selection.

Entities are the basic form of your business organization. At the simple end are sole proprietorships and partnerships, and as we go up the complexity latter these quickly devolve into a letter salad of C-, S- and B-Corps, LLCs and LLPs, and hybrids of more than one of the above. Earlier this week, I was explaining to a client that his best course of action might be to start an LLC that’s also a B-Corp and an S-Corp. This might seem a bit ridiculous, but each of these designations brings specific advantages and choosing the right one can save you taxes and protect you from liability while striking the right balance on a sliding scale of state fees, management structure requirements and attractiveness to investors.

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.

What is an entity and why do I want one?

As Mitt Romney would say, a business is a person. That person – the entity – is either you, the individual business owner, or a fake person that you create on paper to conduct business for you. The fake person, which is a corporation or LLC, is a useful tool. It can be bought or sold, split into shares, managed by directors, own property and intellectual property, make contracts, handle profits in ways that save taxes, and shield its owners from lawsuits.

When the individual or individuals are the entity, the business is referred to as a sole proprietorship or a partnership. This is the simplest and least expensive entity to form, and for some simpler businesses it is sufficient. It avoids “double taxation” on profits that are a disadvantage of some corporations – profits go directly to the owner’s income for tax purposes, but are subject to self-employment taxes, a system known as “pass-through” taxation. The primary drawbacks are that it is difficult to sell or to bring in investments, that it leaves its owners exposed to lawsuits and business creditors and that it does not lend itself to being managed by people other than the owner.

Corporations: The traditional approach

The corporation is the traditional alternative to the sole proprietorship or partnership. It is a fake person, created by filing paperwork with a state, for the purpose of conducting business. It is governed by state laws requiring it to follow certain formalities: It must have shareholder, directors and officers, and must make yearly filings. The Board of Directors must hold meetings and the company must arrange regular shareholder meetings.

In the small company context, this can lead to some rather silly situations in which the company owner must hold regular meetings with himself or herself, send and acknowledge notification of those meetings, and take and keep meeting minutes. These formalities should not be ignored: they are one element of maintaining a working corporate liability shield.

The liability shield, or “corporate veil,” is a valuable if imperfect protection between the company owners and exposure to creditors, including civil lawsuit judgment creditors, of the corporation. Valuable because it means that in most common lawsuits, debt defaults or business bankruptcies, only business assets are at risk. Imperfect because it cannot deflect all types of liability, and failure to follow certain rules can expose the shareholder to “veil piercing” that may invalidate the liability shield.

If a corporation is not an S-Corp or a B-Corp, it is referred to as a C-Corp. Most large or publicly traded companies are C-Corps. The greatest drawback of C-Corp status is what’s referred to as “double taxation” of profits, in which the corporation pays tax on income, and then the shareholder pays tax on profits passed to the shareholder as distributions.

There are other options

Watch this space for my next article, in which I will cover LLCs – the common and simplified alternative to corporations – as well as S-Corp status (a way to avoid double taxation) and B-Corps (a new model for businesses that wish to incorporate public benefits and sustainability into their model).

When is it safe to use independent contractors in Massachusetts?

For a small business, hiring employees can seem daunting, with payroll, tax and other compliance issues taking time from your busy schedule. It is tempting to instead use part-time independent contractors, pay them in “1099 income” and shift the tax and administration burden off your shoulders. Be careful: Massachusetts now has some of the country’s tightest employment classification laws, and interprets them strictly. You can get in much more trouble than it’s worth by misclassifying an employee as an independent contractor, and a simple “Independent Contractor Agreement” is often not enough to protect you.

Note: As always, this article is provided for general education only and to make the reader aware of the issues. If you need advice on your own or your business’s situation, consult a lawyer. This article pertains to Massachusetts law; other jurisdictions may have very different laws on independent contractors.

One common misconception is that the use of an independent contractor agreement is always sufficient to give your hire independent contractor status. If only it were that easy! An independent contractor agreement is only one piece of the puzzle. It will have no effect if the hire is not in a lawfully classifiable independent contractor position.

How do you know whether your hire’s independent contractor classification is lawful? Unfortunately, as in many areas of law, you don’t know for sure until the issue “hits the fan.” Many businesses could go on for years using misclassified workers and not realize the mistake until a complaint or other event results in a state agency or court needing to decide the issue, so instead of trying to write out a bright-line rule I will tell you the criteria that a Massachusetts judge would apply when deciding whether a worker is truly an independent contractor.

There are three criteria. A worker is not lawfully classified as an independent contractor unless all three prongs are met. If the answer to any of these questions is “no,” the worker must be an employee, not an independent contractor:*

  1. Does the worker have freedom from control by the employer? This means that the employer may tell the independent contractor what needs to be done and by what deadline, but should not place any unnecessary requirements on the manner in which the tasks will be done, such as where, during what hours, and by what methods. If the worker submits a time card and is paid by the hour, that will also weigh against independent contractor status. Usually, independent contractors should be paid by the task, not by the hour.
  2. Is the worker performing a service that is outside the employer’s usual course of business? This requires considering the employer’s line of business, and asking whether the independent contractor is doing something that is part of that business or would ordinarily be done by a separate company. If the business is a shoe store, it is unlikely that it would get away with classifying its shoe salespeople as independent contractors. But the graphic designer it hires to do its print ads? If handled properly, that can usually be an independent contractor. Software developers working for a software company? Probably an employee. Videographer hired to prepare web ads before the software company’s product launch? Usually an independent contractor.
  3. Is the worker engaging in an independently established trade or business? This sounds a lot like number 2, but what it is asking is whether the worker is a separate business entitled to act like one. Merely forming a separate LLC or Corporation is insufficient. Is the worker free to take on other projects for other companies, so long as they don’t conflict? If the worker is (or is in a line of work where traditionally he or she would be) advertising the services he or she is performing for the employer to other potential employers, scheduling time for the multiple projects and doing them independently, this prong will be satisfied.

Again, if the answer to any of these questions is no, you must sign the worker on as an employee, not as an independent contractor. Failing to do so could result in your company inadvertently violating a number of state laws, including (but not limited to) payroll record keeping rules, payroll tax withholding requirements, wage and hour law, minimum wage law, laws requiring overtime pay, and worker’s compensation laws. Companies found in violation of these laws could receive stiff fines and be prohibited from working on public contracts for a period of time.

*There are a few specific exceptions to this rule that are specified in Massachusetts statutes. For example, real estate agents usually sign on to a single company and would certainly appear to be employees under this law, but there is a separate law regulating real estate companies that specifically allows them to use independent contractors as agents. Taxi drivers, lawyers and a few other professions receive similar treatment.

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.

The Alice Corp case: What is it?

It’s hard to read an article about patents these days without a reference to Alice Corp. v. CLS Bank. When the Supreme Court’s opinion in the case came down it was not really surprising to anybody who had been paying attention, but it is important and (even though it’s several months old) not actually that well understood, so here is a short explanation.

What Alice Corp., the patent holder, had done was to patent a system in which an intermediary company, helps parties to a transaction manage their risks by holding up a transaction and not completing it until after confirming that each party has provided the resources that satisfy the obligations, using a computer to log the details of the transaction and compare the requirements to the resources provided by each party.

This is, in essence, escrow. It is a concept is nearly as old as banking itself, making it unpatentable for lack of novelty, and it is also unpatentable because it is a mere concept. The Court’s holding focuses on the second reason why escrow is unpatentable, but the point here is that if a party tried to patent escrow it should fail. What Alice did was to add a computer to the process. That actually worked at first, because it initially did result in a patent issuing, back in the good old days when you could patent toast and playing with cats with a laser pointer – the 1990s. But adding “use a computer” to otherwise unpatentable subject matter does not result in patentable subject matter, so in 2014 the Court ruled that the patents were invalid.

Somehow, this outcome seems to have surprised some observers. It should not have. The Alice case follows on Bilski v. Kappos, a 2010 case that did the same thing to a party that had patented investment hedging, plus a computer.

There are two takeaways here:

  1. You can’t patent an abstract concept. Escrow and hedging are too abstract to be considered “inventions”.
  2. You can’t transform ineligible subject matter into eligible subject matter by adding a computer.

Note: As usual, this is not legal advice, but merely education and commentary. If you have any questions on a matter related to patent eligibility, please consult an intellectual property attorney.