Selecting the Proper Business Entity: The Importance of Doing It Right the First Time
Inc., Corp., P.C., LLC, PLLC, RP, LLP, RLLP, CCorp, SCorp ? no, this is not a secret code from the Pentagon, and you're not looking into a bowl of alphabet soup. These are just some of the abbreviations for the types of business entities that are commonly used to own and operate a business. Getting through the maze of state and federal laws can be frustrating for individuals who are good at what they do and want to run a profitable company, but don't have the time or interest to get bogged down in legal jargon even before their first dollar is in the door. Selecting the appropriate legal entity for your business before you hang the "Open for Business" sign on your door can avoid legal hassles and more importantly can save you thousands of dollars in taxes and other expenses in the future.
So the question is: What is the best entity for the construction industry, and what are some of the basic legal issues facing these companies?
Partnership or Corporation?
Traditionally businesses were owned by a sole owner and called a sole proprietorship. If there were more than one owner, then the business was deemed a partnership. The advantage of this is that if owners had profits from one business and losses from another, they could use the losses to offset the profits, thus resulting in lower taxes. The great disadvantage of this structure is that if business owners faced any type of liability (e.g., accidents on their premises, construction injuries, workers causing injuries to others, unpaid debts, etc.), then the business owners' personal assets were subject to attachment to satisfy the obligation. In other words, if there were a construction accident and the construction business owners were found to be at fault, the injured party could seek payment from all the owners. If they couldn't afford to pay the obligation, their personal property (e.g., homes, cars, bank accounts) would be at risk, even though the personal assets were not part of the business. The law's response to this dilemma historically has been the corporation.
A corporation is a legal entity that is formed by filing Articles of Incorporation usually in the state in which the company's primary place of business is located. The Articles set forth the purpose of the business, its address, the name of a resident agent who receives any official notices on behalf of the corporation, and the number of shares of stock the corporation is authorized to issue. The great advantage of a corporation is that it is a legal entity separate and apart from its owners. Unlike with a sole proprietorship or a partnership, liabilities of the corporation do not result in any risk to the owners' personal property because the corporation is a separate entity.
The governing document of a corporation is its bylaws. The bylaws of a corporation set forth how the corporation will operate, the roles of the different officers, the composition of the Board of Directors, and procedures for election of officers and directors. State law requires that there be at least an annual meeting of the stockholders of the corporation and the Board of Directors, and most states require an annual filing with a nominal fee to remain in good standing. Sounds perfect, right? Wrong.
One problem with corporations is a risk that the corporation and the owners will be subject to what is commonly referred to as a "double level of taxation." This means that, on one hand, when a corporation makes profits, it is taxed on that revenue; meanwhile, when that profit is distributed to the owners, the payment is considered a dividend and the individual receiving it will be taxed as well. Also, if the corporation experiences losses, the owners are not able to use those losses on their individual income taxes to offset salary and other revenues they receive. Seems like a no-win situation, right? Wrong again.
The federal tax code provides a solution, though not a perfect one. The code provides that a corporation can make what is commonly referred to as a Subchapter S Election (Sub S). It gets its name from the section of the tax code and provides that a small business (less than 75 owners) can elect to be treated as a non-entity for federal tax purposes; thus all profits and losses of the business are passed to the owners and there is no corporate level of taxation. Once again, this seems like a perfect remedy, but ? like anything business-related ? there are a few catches.
There are several restrictions on Sub S corporations, including the number of owners, the types of owners (generally requiring U.S. citizenship), and the ability to invest in other entities.
Sub S corporations are preferable and are commonly used by small businesses with few individual owners; however, because of some of these issues, certain businesses continue to use a partnership to operate the business to take advantage of certain tax savings. As we discussed earlier, the big risk of running a business through a partnership is that it offers no protection to the individual partners whose personal property and assets remain at risk. Enter the LLC!
Limited Liability Company
The limited liability company (LLC) is a relatively new business entity and has become the preferred choice for operating most businesses in the last decade, including those in the construction industry.
What is a LLC, and why is it so attractive to business owners? Simply stated, it offers the best of both worlds. That is, it provides the same protection from personal liability as a corporation and provides all the tax benefits of a partnership. Like a corporation, the LLC is a separate legal entity, and its assets are owned separate and apart from the personal assets of the owners, called members.
A limited liability company is created by filing Articles of Organization, similar to Articles of Incorporation for a corporation. The governing document for a LLC is its operating agreement. An operating agreement is a cross between the bylaws of a corporation and the partnership agreement of a partnership. What also is attractive about the LLC for owners, especially those who are not holed up in an office all day, is that state laws do not require the same types of formalities as a corporation. There is no requirement for the members to meet annually or to keep formal minutes, and many states do not even require an annual filing fee. So we don't need to go any further now that the LLC solves all our problems, right? Well, maybe...
There are a few reasons why the LLC might not be advantageous. This includes certain situations where the company owns and transfers certain types of real estate or if the company intends to be publicly traded some day. Changing an entity from a limited liability company to a corporation generally will not create a tax liability; however, changing from a corporation to a limited liability company could result in a significant tax obligation. That is why it is so important to do it right the first time.
What's an Owner to Do?
Totally confused? I hope not. The best advice for the construction industry is that the LLC is probably the most effective and safest business entity; however, it is worth a few hours of professional advice from your accountant and lawyer at the outset to review the exact business being formed and the plans for its growth. It is also important to determine how the business will be continued ? but we'll save that discussion for another bowl of soup!
About the Author
John J. Matteo, Esq., is a Director with the Washington, D.C., law firm of Jackson & Campbell, P.C. He chairs the Business Law Practice Group and specializes in business and commercial real estate matters.
This article is not intended to provide legal advice, but to raise issues on legal matters. You should consult with an attorney regarding your legal issues, as the advice you may receive will depend upon your facts and the laws of your jurisdiction.