Establishing a company: corporation vs. the LLC

Ray  Martin is in the law office of Neal Able. Ray is a master electrician, who is about to form his own electrical contracting company. Ray is seeking Neal’s advice on how best to accomplish this.

In their initial conference Ray and Neal determined that neither a sole proprietorship nor a partnership is an appropriate business format for Ray’s needs, primarily because neither would shield Ray‘s personal assets from the financial risks of the business.

Neal is now talking to Ray about other business options, including forming a corporation, which  many people are generally familiar with, and forming a limited liability company (LLC), which is still a mystery to many folks.

In the eyes of the state of Wyoming, when you form a corporation, you create a new “person.” A corporation is composed of one or more owners, called shareholders, but the corporation is an entity separate and distinct from the individual shareholders, and has a life of its own. It can sue and be sued in its own name. It can own property. If a shareholder dies, or sells his or her stock, the corporation carries on without that shareholder. It has “perpetual” existence.

The most well-known attribute of the corporation, and perhaps its most desirable characteristic, is the limited liability which is afforded to the owners of the corporation — the shareholders — so long as the business is properly organized and so long as the corporate formalities are observed once the business is up and running.

Limited liability means that the financial risk of the shareholder is limited to his investment in the corporation. His personal assets are not subject to claims by creditors of the business. Any judgment against the corporation must be satisfied solely from the assets owned by the corporation, or from corporate income.

Until very recently if limited liability was something you had to have in your business; then forming a corporation was your only practical option, excluding entities such as the limited partnership, the Massachusetts trust and other esoteric forms that people don’t write about in newspaper columns.

In the 1990’s, the LLC, which is short for limited liability company, became an option. In 1977 there was no such thing as an LLC in the United States. In 1999 there are probably as many new LLCs being formed as there are new corporations. Its brief history makes great reading.

Once upon a time there was a very small oil exploration company, Hamilton Brothers, which was doing business in South America. Hamilton Brothers wanted to compete with the big boys in the international global markets, but to do so it needed the stability of being an American entity. But Hamilton Brothers could not maintain profitability as an American corporation because of the manner in which corporate income is taxed. Hamilton Brothers needed the limited liability of the corporate format, but it also needed to be taxed like a partnership.

So, what do you think Hamilton Brothers did? In 1977, one of its savvy corporate legal guys telephoned the business-friendly folks in Wyoming and said, “Have we got a deal for you.”

Hamilton Brothers drafted a legislation package, which created a new business entity in America (although it was in use elsewhere in the world). The new entity, dubbed the limited liability company, was a hybrid between a partnership and a corporation, combining the best features of each. It was promoted in the Wyoming legislature in 1977 as potentially helpful to small businessmen, as a vehicle to allow a family to operate its business, farm or ranch, and as a means to enable a small mineral resources company to raise venture capital.

The legislation sailed through both houses of the Wyoming legislature, as one commentator noted, without so much as a comma being changed.

The governor promptly signed the bill and it became effective on June 30, 1977, the birthday of the LLC.

It took another 10 years for the LLC to become popular because it was not until 1988 that the IRS finally allowed the LLC to be treated as a partnership for tax purpose. That decision was the kiss of life for the LLC concept. Since then each of the 50 states has adopted LLC legislation.

What’s the big deal about being treated as a partnership for tax purposes? A partnership does not pay any income taxes. Income earned by a partnership is passed-through to the individual partners; it is divided between them in accordance with their partnership agreement.

Each partner then reports the income on his personal income tax return, and pays taxes accordingly. Partnership losses are also treated the same way– they are passed-through to the individual and reported on the individual’s personal income tax return. The pass-through feature is often highly desirable to investors.

Ray Martin now has a choice. He may choose the LLC or the corporate format and either will afford him the protection of limited financial liability. But that is just the beginning of the equation. Ray and Neal must analyze other factors as well, especially the tax consequences of choosing either the corporation or the LLC.

Ray estimates that his company will generate $150,000 in revenues in its first year of business, and that it will spend $50,000 for materials, pieces and parts, yielding a net income of $100,000. Is it best to incorporate or to form and LLC? If Ray incorporates, should the company elect to be treated as a “C” corporation or an “S” corporation?

Wouldn’t you know it. Neal has to leave for an important hearing at the courthouse. He and Ray schedule their next meeting for Sep. 15. Guess what happens on that day? That’s when the next issue of the Guide hits the newsstands.