Most business owners understand the need to create an entity to operate their business. However, beyond general knowledge, many owners are unsure of when is the right time to create an entity and which type of entity makes sense for their business goals. These choices are complex and vary for each type of business. This is the first in a series of blogs focused on S Corporations (S Corps) where attorneys in PilieroMazza’s Corporate & Organizational Governance Team explore different S Corp entity types, their tax and ownership implications, and requirements. In this blog, we focus on corporations and LLCs, their liability protections, their requirements, and their tax advantages for small businesses operating in the government contracting and commercial business sectors.

Overview of Traditional Entity Types

Business entities are created pursuant to state law, which varies widely. By default, a single owner operating a business for profit is deemed a “sole proprietorship” and two or more owners operating a business for profit are deemed a partnership, even if no formal filings are completed with a state’s Secretary of State (or functional equivalent). In both cases, the owners are personally and individually responsible for all of the debts and obligations of the business. Further, in the partnership context, each owner is presumed to be solely responsible for all of the debts and obligations of the partnership (i.e., jointly and severally liable). In other words, if an accident occurs on the job and the business is held liable—each owner in these types of entities—is required to pay for the entire liability, including out of their personal, unrelated assets.

These default treatments are overcome by forming a business entity under applicable state law. Most commonly, this takes the form of corporations and Limited Liability Companies (LLCs), but many states offer other forms for unique situations, such as Limited Liability Partnerships (LLPs), Professional Corporations (PCs), and non-stock corporations. Choosing the correct type of entity is important, and the circumstances governing which entity is most appropriate should be assessed on a case-by-case basis. This blog will focus on corporations and LLCs, which is the typical choice for business owners. Upon forming one of these entities and operating any business through the registered entity, any liabilities related to the business will generally only be enforceable against the assets of the entity; however, as discussed below, this is not always the case.

Limitation of Liability

One of the biggest concerns when starting a business is protecting the personal assets of owners. Regardless of whether an entity is an LLC or a corporation, both entities provide liability protection to their members. However, in order to establish and maintain this protection, there are procedures and actions that owners should follow to maintain liability protection, discussed further below. These actions require that owners generally treat the business as a legitimate, separate entity from both the individuals or entities forming the new entity, and any other entities that were formed by those filing for the new entity. For example, corporations are expected to hold annual meetings and to memorialize certain actions in writing. While corporations must comply with ongoing governance rules, the requirements for LLCs are generally much simpler than a corporation, making it an easier entity to operate for most small businesses.

There are many other considerations for choosing an entity type, including (1) the nature of the business, (2) the jurisdiction(s) where it will operate, and (3) whether outside investment is expected. Business owners should work with a qualified legal professional to identify these special concerns and guide them through this choice.

Piercing the Corporate Veil and Personal Liability

The liability protection that comes with corporations and LLCs is not without limits and the tests for determining if violations have occurred are done on a case-by-case basis. Best practices for following corporate formality steps include, but are limited to, actions such as:

1. maintaining separate business accounts for the business,
2. ensuring the entity remains in good standing in each state it is required to register,
3. maintaining proper corporate procedures and documents, such as meeting minutes, and
4. ensuring no members commit “ultra-vires” acts, which a court would deem outside the scope of the normal business of the company.

Violations of corporate procedures may result in the so-called “Piercing the Corporate Veil,” meaning business owners will be held personally liable for the debts of the business. There is no “bright line” rule on the frequency or type of violations required, but courts applying this principle typically conclude that the owners failed to treat the business as a separate entity, thus losing the liability protection the entity provides. The end result is the same as if the business was operated as a sole proprietorship or partnership.

In short, if your business is a sole proprietorship or partnership, the first step would be to create a business entity and move the operations of the business to the entity name (rather than your individual name). Remember, the right structure depends on your business goals and individual circumstances. Always consult with an attorney to understand the implications of each choice for your business.

Tax Considerations for Tax Status of Entities

Many business owners will say that they own an “S Corp,” which is a common misnomer. Unlike the legal forms of entities discussed above, the IRS recognizes the following types of for-profit entities for taxation purposes:

1. Sole Proprietorships or “Disregarded Entities” (1 business owner);
2. Partnerships (2 or more business owners); or
3. Corporations organized pursuant to state law and taxed under either (a) Subchapter C (C Corps), by default, or (b) Subchapter S (S Corps), pursuant to a qualified election.

Notably missing from this list are LLCs, which the IRS recognizes as a form of legal entity but it is not a recognized tax status. Instead, by default, a single-member LLC is taxed as part of the LLC owner’s tax return (a disregarded entity), and a multi-member LLC is taxed as a partnership (a pass-through entity).

Of course, LLCs can make affirmative elections to deviate from these defaults, including by electing to be treated as an S Corp. As demonstrated above, corporations can also elect to be treated as an S Corp. Whether to make such an election is usually driven by tax considerations, and an entity contemplating the S Corp election should evaluate the choice with their tax professional. That said, there are also important legal considerations that should be discussed with an attorney.

So, when someone says they own an “S Corp” or want to establish one, it is important from a legal perspective to know whether they mean: (1) an LLC taxed as an S Corp or (2) a corporation taxed as an S Corp. For tax purposes, they are treated identically and as pass-through entities. But legally, the two entities are very different in their legal treatment and governance requirements.

S Corp Requirements

As mentioned above, a qualifying entity must make an affirmative election to be treated as an S Corp. To qualify for S Corp status, the corporation or LLC must meet the following requirements:[1]

1. be a domestic corporation or LLC;
2. have only one class of stock;
3. have only “allowable” shareholders: (a) may be individuals, certain trusts, and estates and (b) may not be partnerships, corporations, or non-resident alien shareholders;
4. have no more than 100 shareholders; and
5. not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations).

Again, these requirements are the same for either corporations or LLCs that wish to make the election. In the LLC context, references to “shareholders” apply equally to members or interest holders, and the term “stock” applies to interests or units; these terms vary according to state law and the operating agreement, but the concepts apply with equal force to LLCs.

The requirement most often discussed is that an S Corp must have a “single class of stock.” In simple terms, S Corps are deemed to have one class of stock if all outstanding shares confer identical rights of distribution and liquidation proceeds. Problems can arise in an LLC where a governing document (i.e., Bylaws or Limited Liability Company Agreement) authorizes a manager or officer to make distributions in their sole discretion, which would allow for distributions to be made that are disproportionate to ownership. Actual disproportionate distributions would be a clear violation of S Corp requirements, but, as will be discussed in the next installment of this series, the discretion to make disproportionate distributions may also be deemed a violation of S Corp status.

S Corps should also be careful about implementing a “phantom equity plan,” without fully integrating the plan into the overall structure of the entity. Also, certain agreements that confer liquidation preferences, including some debt arrangements, may lead to a violation of S Corp rules. In short, provisions in any sort of agreement that give any sort of preference in payments should be carefully scrutinized. Always consult a legal professional to ensure that such plans or agreements do not create a second class of stock.

To be clear, all of the above S Corp requirements must be continually satisfied. Additionally, because the status is intended to benefit small businesses, there are ongoing income requirements that must be met. Primarily, an S Corp is not intended to be an investment vehicle. As such, S Corps should maintain any passive income below 25% of the entity’s gross receipts to avoid paying corporate rates on excess income from passive activities. Entities electing S Corp status should work closely with their tax professional to monitor this and other requirements.

Takeaway

Each entity type and tax status has different implications for liability, ownership, and taxation, so it’s important to choose the one that best fits your business needs. It is essential to work closely with legal professionals who can guide you through the process effectively and ensure legal compliance. In the next installment of this blog series, we will discuss terminations of S Corp status and corrective measures to restore S Corp status.

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[1] See 26 U.S. Code § 1361.