Starting a Business: Is an LLC or corporation right for you?

Starting a business? Great! It’s an exciting time. But it’s also a time packed with questions, hundreds of them, all demanding an answer now. A big one is what kind of business form to use. For help with that, keep reading.

Previously, I introduced the kinds of legal entities that you can choose for running your business. Those entity types were sole proprietorships, partnerships, corporations, and limited-liability companies. That article focused primarily on the first two. Now let’s take a deeper look at the other two—corporations and LLCs.

The term “corporation” calls to mind globe-spanning companies like Apple, Toyota, and Exxon Mobil. But corporations are not limited to the titans of industry. In fact, most are owned and operated by people like you.

A corporation, unlike sole proprietorships and partnerships, is a legal entity separate from its owners. These owners are known as shareholders. Meanwhile, the corporation’s day-to-day affairs are handled by directors with job titles like president, secretary, and treasurer. For small corporations, some or all of the shareholders are usually also the directors.

The biggest reason people create a corporation is to limit their liability. Unlike a sole proprietorship or partnership, owners have limited liability for the corporation’s debts. In other words, if the corporation’s business is going badly or it loses a pricey lawsuit, creditors can chase the corporation’s assets but not the shareholders’ personal assets. The only thing an owner loses is the time and money they invested in the corporation—nothing more.

Consider an example. Al and Bob want to open a coffee shop, the Pacific Café. They set up a corporation with themselves as both the shareholders and directors. They each kick in $10,000 and get a $50,000 loan, all of which is used to buy equipment and secure space. Business is good for a time and they pay back half of the loan plus their original investment, leaving a total debt of $25,000. But new coffee shops emerge, drying up the Café’s profits. And then things get worse: A customer slips on a puddle during a rainstorm, badly hurting herself and leading to a $25,000 lawsuit. If the Café closes up shop, how much of its $50,000 debt are Al and Bob personally liable for? None—barring several exceptions that we’ll address in a future article.

One of the prices for a corporation’s limited liability is a heightened level of formality. Corporations need to issue stock, elect officers, and hold regular board and shareholder meetings. They also need to keep meetings of those minutes, follow the Commonwealth’s statute governing corporations, and so on.

That brings us to everyone’s favorite topic: tax. How a corporation is taxed depends on what kind of corporation you select. There are two flavors: S corporations and C corporations.

S corporations are treated like partnerships where profits and losses go straight to the shareholders and are reported on each shareholder’s personal tax return. In this version, profits are only taxed once.

C corporations are different. They pay taxes on all profits and then shareholders pay tax on any money they receive from the corporation. This is often called double taxation.

If double taxation sounds unappealing, you have a variety of ways to soften the blow. One option is to pick our final entity choice—an LLC. LLCs share the best of sole proprietorships, partnerships, S corporations, and C corporations.

For one, LLCs enjoy limited liability just like an S or C corporation. Thus, generally speaking, owners of an LLC (known as members) are not personally liable for the LLC’s debts.

For another, like a sole proprietorship, partnership, or an S corporation, LLCs do not pay income tax. Instead, the LLC’s income “passes through” the business to each owner, who then pay tax on their personal tax return.

Careful readers will have noticed that LLCs and S corporations have limited liability and pay no income taxes. If so, you are probably wondering what’s different between the two? Several things.

First, only U.S. citizens or residents can own an S corporation. But anyone can own an LLC.

Second, S corporations have to distribute profits according to the percentage of stock each owner holds. LLCs are more flexible; owners can distribute profits in whatever way they agree.

Third, S corporations need to closely follow corporate formalities to maintain limited-liability protections. LLCs generally just need to make sure that the management team agrees about major decisions.

And, fourth, S corporations cannot pass business debt to its shareholders unless the shareholder personally cosigned or guaranteed debt (not something I would recommend). LLCs, on the other hand, normally allow for debt to be passed through to its owners. Why does that matter? Because it can mean a nice tax break for the LLC owner.

So, what should you take away from this article? You have choices. But which choice is best will depend on several factors, ranging from those we’ve discussed like limiting liability and taxes to others we’ll discuss in future articles.

To make the right choice, invest some time and money on the front to end to speak with both your attorney and accountant. That is doubly true if the business will have more than one owner. An hour of conversation now will pay for itself many times over in the months and years to follow.

Good luck. (Jordan Sundell, Special to the Saipan Tribune)

Jordan Sundell is a lawyer primarily practicing business and real-estate law. He formerly worked for the CNMI Supreme Court and Bridge Capital and is now general counsel for several real-estate companies, including Joint Marketing. His columns—focused mainly on real estate and small business—are published every other Tuesday.