LLC, S Corporation, L3C, Benefit Corporation?
Every profession has its hazards. For mine, it’s lawyer jokes and requests for free legal advice. This blog contains neither, but it will provide a little education on the basic options when forming a company so you’ll sound smart when you call your own counsel.
The legal steps to starting a company are fairly straightforward. First, register with the state. Second, ask the IRS for a tax identification number. Third, set up the governing documents, like bylaws or an operating agreement. Sounds simple, but there’s a lot of tiny decisions that have to be made along the way that could have lasting implications for future owners. Some states offer a larger array of options; this blog discusses the most popular entity choices including corporations, LLC, low-profit limited liability companies (L3Cs), and benefit corporations.
For many years, the only option for someone who wished to organize a business was to form a corporation. They have shareholders and are formed by filing Articles of Incorporation with the state. These Articles spell out the basic purposes of the corporation, who will be liable for its formation, and who will act as a representative for the corporation if it gets sued. People choose to form as a corporation mainly because they are familiar and one of the oldest types of entities. Its often the best form for bringing in institutional capital in later rounds of investment.
The IRS presumes every corporation will be taxed as what people call a “C Corporation.” The name refers to the section of the tax code that governs their taxation. C Corporations are what most people think of as basic or regular corporations. The entity is legally distinct from its owners and is taxed as a legal person separate from its owners. Thus, every dollar of profit in a C Corp is taxed twice, once at the corporate level and once when the profits are distributed to the owners. Why would anyone want that, you’d ask? A few reasons. First, if you want a corporation and will have more than 100 shareholders or will have shareholders who aren’t natural persons (like PE funds or other institutional investors), then a C Corp is your only option.
If you’ll have fewer than 100 shareholders none of whom will be institutional investors, then you’ll want to elect to be taxed as an S Corporation, or S Corp for short. This means it is structured the same as a C Corporation with shareholder owners, but it is taxed like a partnership where income generated by the S Corporation “passes through” to the individual owners who are then taxed on that income. Unlike in a C Corp, all the income of the S Corp shows up on the owners’ personal tax returns, avoiding the double taxation of C Corps.
Because of the tax advantages of S Corps over C Corps, the IRS limits the types of entities that can own S Corps. The S Corporation can have only one hundred shareholders, none of whom may be foreign individuals, other corporations—unless those corporations are tax- exempt—or certain trusts. Thus, the S Corp has become known as the “small business corporation” because of the limits on the # and type of owners.
Another emerging option is the benefit corporation. Thirty-two states have enacted legislation, making the new corporate form available, and eleven others have introduced such legislation.Cite Benefit corporations are essentially similar to traditional corporations, but are required to simultaneously pursue profit and social good. Although sharing a similar name, benefit corporations are not the same as B Corps (and may or may not be certified by B Lab as B Corps).
Some states offer similar corporate forms, such as the flexible purpose corporation (FPC) or social purpose corporation (SPC). Benefit corporations are created to pursue profit and social and environmental benefits. While the corporation is required to create a net positive impact on the environment and society, it can also include one or more specific public benefits, for example, to support a particular nonprofit organization.
Every state has somewhat different benefit corporation legislation, and there are still many gray areas surrounding the entity because it is so new, having been first recognized in 2010. Many within the legal community are uncertain as to how the entities will be run, when their directors may face liability, and how the entity will be taxed in the future.
The taxation of a benefit corporation will be similar to regular corporations—either C Corp double taxation or S Corp pass-through taxation creating UBIT for the charity owners.
A charity enterprise could also become a limited liability company (LLC). All of these entities are pass-through entities (like the S Corporation), meaning income is taxed to the individual receiving it and not to the entity unless the LLC elects to be taxed as a C Corp with double tax.26 The owners of an LLC are called “members,” and if they are the ones that run it, then the LLC is called a manager-managed LLC. If, on the other hand, non-members are the ones in charge of the LLC’s operations, that LLC would be classified as a manager-managed LLC.
A major benefit to the LLC as an entity is its incredible flexibility. The governing document for an LLC is called an Operating Agreement, and it is essentially a contract that can be tailored to the needs and wants of the members. For example, an owner with 60 percent of the vote can be allocated 40 percent of the profit—a helpful proposition if you want to bring in new investors with less control but a greater share of the profits. Not only do LLCs provide a great deal more flexibility than corporations, but they also provide their members with limited liability, unlike a partnership or sole proprietorship. So, in a sense, the LLC is the best of both worlds.
At the beginning of the social enterprise movement, most social enterprises used regular corporate forms to pursue social good. They would amend the company’s articles of incorporation and/or bylaws, or operating agreement in the case of an LLC. Since then, hybrid social enterprises have emerged. Hybrid social enterprises are legal entities that have a social mission encoded into their DNA, so to speak.
In the past few years, a few states have begun offering a new type of business entity specifically crafted to suit the duel purposes of social good and, secondarily, profit for investors. The L3C—or “low-profit limited liability company”—is intended to combine the mission of a nonprofit with the efficacy and perquisites of an LLC. Unless state statutes provide otherwise, the L3C is treated as an LLC for all legal and tax purposes.
There has, however, been significant debate regarding this entity. Although its creators wanted it to attract program-related investments from private foundations, the IRS has not issued the regulations to officially recognize this avenue. There is also a great deal of disagreement over the L3C’s usefulness.
Daniel S. Kleinberger, a prominent legal scholar, articulated his strong feelings on the subject, saying, “The L3C is an unnecessary and unwise contrivance, and its very existence is inherently misleading.”Cite LLCs are already highly customizable and provide members with limited liability, and their Operating Agreements can be crafted to serve the desires of the members including making the LLC a primarily mission-driven organization.