New York Small Business Law

NY S Corporations v. LLCs - The 2010 Edition

Prologue:  This is a long overdue update on an old classic: Choosing between an S corporation and an LLC - The New York Perspective.

Many small business owners end up deciding between a New York S corporation and a New York limited liability company (LLC) when choosing a formal legal structure for their New York business. Both entities offer limited liability and a startup friendly tax treatment. But which entity is right for your small business? The following are some frequently asked questions with respect to the two business entities.

What is an S Corporation?

An S corporation is a (regular) business corporation that elected a special tax treatment with the federal tax authorities and/or the New York State tax authorities.

Otherwise, an S corporation’s characteristics are just like a regular business corporation, which means that it is a legal entity that can be formed by one or more persons. Once a corporation is formed, the S corporation (not its owners in their personal capacity) will enter into all contracts, issue all invoices and undertake all business activities.

Note: Professionals can only form a professional corporation.

What is a Limited Liability Company?

A limited liability company (LLC) is a business entity that can be formed by one or more persons or other business entities.

Once an LLC is formed, the LLC (not its owners in their personal capacity) will enter into all contracts, issue all invoices and undertake all business activities.

Note: Professionals can only form a professional limited liability company.

How do I form an S Corporation?

You start by forming a regular business corporation.

The formation of a corporation requires the filing of a “certificate of incorporation” with New York’s Department of States.

Once the corporation is in existence, you will have to elect S corporation status with the federal and state tax authorities.  

How do I form an LLC?

The formation of an LLC requires the filing of “articles of organization” with New York’s Department of State.

Who can form an S Corporation?

Only individual U.S. citizens or U.S. residents can form an S corporation.

Who can form an LLC?

Any person or business entity.

How many Shareholders can an S Corporation Have?

An S corporation can only have a maximum of 100 shareholders all of which have to be individuals (some exceptions apply).

How many Members can an LLC have?

An LLC can have an unlimited number of members.

Who are the Owners of an S Corporation?

The owners of an S corporation are called shareholders. The corporation issues share certificates to the shareholders in exchange for something of value, like cash, services or property.

Who are the Owners of an LLC?

The owners of an LLC are called members. You become a member by contributing something of value (cash, services, property) to the LLC and receiving a membership interest in return.

How much does it cost to form an S Corporation?

It costs about $195 to form a corporation in New York, excluding legal fees.

How much does it cost to form an LLC?

It costs about $1300 to form a limited liability company in New York, excluding legal fees.

The main costs of formation stem from the fact that limited liability companies are required to publish their formation in two newspapers. Depending on your location, this publication requirement can be quite costly. The estimated cost of formation above is based on New York county’s expensive newspapers (about $1000), it may be cheaper in other counties.

How long does it take to form an S Corporation?

For $195, your corporation will be in existence within 24 hours. However, you normally have to wait a couple of days to receive the necessary documents in the mail to prove that your corporation has been formed. This may be necessary for opening a bank account.

How long does it take to form an LLC?

You can form an LLC within 24 hours. However, you normally have to wait a couple of days to receive the necessary documents in the mail to prove that your LLC has been formed. This may be necessary for opening a bank account.

Many banks will also require you to show an operating agreement (see discussion below) before they will open an account for your LLC.

The publication requirement has to be completed within 120 days of formation. Notwithstanding, you can start doing business with your LLC as soon as it is born. If you fail to fulfill the publication requirement, your business loses the authority to conduct business in New York with the expiration of the 120 day period.

Does an S Corporation offer limited liability to Shareholders?

As long as you keep up with all corporate formalities, a corporation offers almost complete limited liability. Shareholders only risk losing the initial investment in the corporation. Creditors normally cannot reach the shareholder’s personal assets.

Does an LLC offer limited liability to its Members?

Yes, the LLC is liable on all business debts, not the members personally. If the business goes under, creditors of the business cannot reach the personal assets of the members.

What formalities are required to maintain an S Corporation?

Among other formalities, S corporations require annual shareholder and director meetings. Important decisions by the S corporation must be documented in “minutes” or “written resolutions” of shareholders’ or directors’ meetings.

Formalities are important to preserve the “limited liability shield” of the S corporation.

What formalities are required to maintain an LLC?

LLCs require less ongoing paperwork than S corporations; however, unless the operating agreement (see below) of the LLC states otherwise, the LLC must also hold annual member meetings.

Formalities are important to preserve the “limited liability shield” of the LLC.

Can an S Corporation issue Shares with different economic rights?

No. All shares of the S corporation must have the same economic rights to profits, distributions and liquidation of assets.  In other words, a shareholder who owns 50% of the shares of the S corporation can only receive 50% of the distributions of the S corporation.

Can an LLC have Membership Interests with different economic rights?

A special feature of an LLC is that the members can agree to share profits and losses in proportions different from their membership interests. In other words, the members could agree that 100% of the profits of the LLC are to be distributed to one member for the first three years, despite the fact that that member owns only 50% of the LLC and normally should have received only 50% of the profits and losses.

But these so called “special allocations” have to follow quite complicated tax rules to make them permissible. This adds a layer of complexity and extra cost to the management and accounting for the LLC.

Who manages an S Corporation?

A “board of directors” manages the affairs of the corporation through officers. Officers of a corporation are often named president, vice president, treasurer, secretary, chief operating officer and so forth. Sometimes the law or the “bylaws” of a corporation provide that the shareholders have to approve certain actions by the corporation. Bylaws are rules that govern the corporation. When a corporation is formed, the initial directors approve the original bylaws of the corporation.

All three groups in the corporation, directors, shareholders, officers, can be the same person. In other words, if you form a corporation and are the only shareholder, you will also be the only director and may be several officers in one.

Who manages an LLC?

An LLC can be managed by its members or by appointed managers. Unless the articles of organization of the LLC provides for management by managers, the LLC is managed by its members.

What is a Shareholders Agreement and do I need one?

Shareholders can enter into a shareholders agreement to regulate certain matters that come with their share ownership. For example, unless you agree with your fellow shareholders in a shareholders agreement that the shares are not “freely transferable”, any shareholder would be able to sell his shares to a third person. Such person would then become a co-owner of the business.

Thus, unless you are the sole shareholder of your corporation, it is advisable to enter into a shareholders agreement.

What is an Operating Agreement and do I need one?

Members of an LLC (even a sole member of an LLC) must enter into a written operating agreement.

Similar to a shareholders agreement, an operating agreement regulates ownership of the LLC and the business affairs of the LLC. For example, you can put restrictions on the transferability of the membership interests.

Does the S Corporation pay Taxes?

Not on the federal level, but for exceptions in New York State and New York City, see note below.

A regular business corporation is a taxpayer separate from its shareholders. The corporation pays taxes on its profits. When the corporation distributes profits to the shareholders (called dividends), the shareholder have to pay tax again on such distribution. This is called “double taxation”. By electing S corporation status, S corporations avoid this double taxation.

Each individual S corporation shareholder will include her share of the S corporation’s income, loss, and deductions on her individual state and federal tax return.  For this reason, an S corporation is also known as a "pass-through entity."

Note: 

New York State does not exclude s corporations from all corporate level taxation.  

New York City does not recognize S corporation status. Consequently, a New York S corporation having income form New York City sources will be taxed as a corporation for New York City tax purposes and has to pay New York City's General Corporation Tax. 

Does an LLC pay Taxes?

A one-member LLC is treated as a “disregarded entity.” The only member reports income, losses, and deductions of her LLC on her personal federal and state income tax return like a sole proprietor.

A multi- member LLC is normally treated as a partnership for tax purposes. Just like a partnership, the LLC does not pay taxes, but files an informational return

Members report their share of the LLC's income, loss, and deductions on their individual state and federal tax return.  For this reason, an LLC is also known as a "pass-through entity."

Can a Shareholder deduct Losses of the S Corporation?

Yes, a shareholder of an S corporation can deduct her share of the losses of the S corporation. However, there are limits. Compared to LLCs, S corporations allow for less loss deduction.

Can a Member deduct Losses of the LLC?

Yes, a member of an LLC can deduct her share of the losses of the LLC.

Do Shareholders have to pay Self-Employment Taxes on Money they receive from the S Corporation?

No. However, shareholders of an S corporation who work for the business have to pay themselves a reasonable salary. They are considered employees of the S corporation. Consequently, the S corporation has to withhold federal and state taxes from their salary, pay unemployment insurance and its share of social security and Medicare payments.

There still may be savings over the self-employment tax due from members of an LLC. S corporations can pay out all profits above a reasonable salary as dividends to their shareholders. There are no self-employment taxes or other employment taxes due on such payments.  In determining a "reasonable" salary, be aware of the audit risks involved.

Do Members have to pay Self-Employment Taxes on Money they receive from the LLC?

Members who are actively involved in the business of the LLC have to pay 15.3% self-employment taxes on the first $106,800 of their combined wages and net earnings, including the income allocated to them from the LLC. 

Can a Shareholder be an employee of an S Corporation?

Yes, by default, anybody working actively in the S corporation is considered an employee; i.e. the corporation must do payroll for the employee: withhold federal and state taxes, pay its share of social security and Medicare, and pay unemployment insurance. The corporation can deduct the cost as expenses.

Can a Member be an Employee of an LLC?

No. A Member cannot be an employee of an LLC.  Even though a Member can actively work in the management of the LLC and receive so called "guaranteed payments" similar to a salary, technically he or she would not be considered an employee.

Can an S Corporation choose a different Tax Status?

An S corporation can choose to abandon s corporation status and become a regular corporation again. There are limits and restrictions on how often the switch can be done.

Can an LLC choose a different Tax Status?

An LLC can choose to be taxed as a corporation or a partnership.

Can I raise money for the S Corporation from outside investors?

The S corporation can issue shares to investors in exchange for capital that can be used to grow the business. Investors will become owners of the corporation, but can be excluded from management (if they agree).

Can I raise money for the LLC from outside investors?

The LLC can issue membership interests to investors in exchange for capital that can be used to grow the business. Investors will become owners of the LLC, but can be excluded from management (if they agree).

For their own valid reasons, certain venture capitalists will require a corporation for their investment.

Bottom Line for S Corporations:

Pros:

An S corporation is cheaper to form than an LLC.

More people are familiar with the structure of an S corporation.

It may be possible to save money on self-employment taxes.

Cons:

S corporations put serious limitations on the number and kind of permitted shareholders.

S corporations do not allow for special allocations and are less flexible than LLCs.

S corporations put limits on loss deductions on the shareholder level.

S corporations require ongoing formalities to preserve their limited liability shield.

S corporation status is not recognized by New York City, thus the s corporation is subject to corporate level tax.

Bottom Line for LLCs:

Pros:

The LLC offers a very flexible structure. Members can agree to special allocations of profits and losses.

The LLC offers more possibilities for loss deductions.

LLCs have no limitations on the number and kind of owners.

LLCs require less ongoing formalities.

Cons:

LLCs are expensive to form.

LLCs are expensive to maintain when special allocations are chosen by the members.

LLCs can be more complex with respect to accounting procedures.

LLCs can be more expensive for the members with respect to self-employment taxes.

**This post is for informational purposes only and does not constitute legal advice**

Can a Limited Liability Company issue Share Certificates?

Yes, but they would typically be called membership certificates or units.

In my experience, small businesses rarely issue such membership certificates.

Typically, when two or more people form an LLC, they form the entity by filing the necessary paperwork with the Department of State and then enter into an operating agreement between themselves and the entity.  The operating agreement will state something to the effect that A,B and C each contributed x amount of money (or services or property) to the LLC and received membership interests in the percentages expressed on some annex to the operating agreement.  No actual paper certificates will be issued.

However, that doesn't mean that an LLC cannot issue certificates similar to share certificates of a corporation.  An LLC is very flexible and you can choose to structure your LLC almost like a corporation by including appropriate provisions in the operating agreement. 

While membership certificates would add an extra layer of formalities to an LLC, they could offer some advantages:

It may be easier to create a security interest in a certificated membership interest, and

you can put a "legend" on the certificates that alerts third parties that the certificate is subject to transfer restrictions in the operating agreement.

Related Post:  The LLC Operating Agreement - Keep it Simple

**This post is for informational purposes only and does not constitute legal advice**

Incoming Google Search: is it legal to sign a contract as an LLC that is not yet formed?

I guess it isn't illegal, unless you think doing something stupid should be illegal.

But I can see how this can happen.  You are presented with the perfect business opportunity and are pressured to enter into a contract.  You know that you should probably wait until your LLC has been formed, but you cannot wait until "FileYourLLC.com"  actually gets around to doing it (you opted for the "basic" LLC formation package which indicated 2-3 weeks processing time).

So you figure, why not sign in the name of the LLC, nobody is going to ask later.  Bad idea.  If you sign for your LLC despite the fact that the LLC has not been formed, you are likely personally liable on whatever obligation you signed for.  You may or may not be able to get the other party to the contract release you once the LLC has been formed.

So, if at all possible, wait until your LLC has been formed by filing the articles of organization with the Department of State.  If you are really in a hurry and are ready to pay extra filing fees for expedited handling, you can form an LLC within 2 hours, so there is really no reason to risk personal liability on any contracts entered into before the LLC came into existence.

**This post is for informational purposes only and does not constitute legal advice**

I think I pierced my Corporate Veil - Is this Fatal?

Don't go to the emergency room yet.  Your awareness of something going awry in your corporation maybe the first step to recovery.

First off, you can't really "pierce" your own corporate veil.  "Piercing the corporate veil" is lawyer talk for somebody else trying to make you personally liable for your corporation's debt.

Usually a corporation protects you from the corporation's creditors.  The corporation is considered a separate entity.  If the corporation enters into a contract, only the corporation is liable, not you personally, even if you are the sole shareholder, director and officer of the corporation.

Now, this corporate separateness can sometimes lead to injustices.  For this reason, courts came up with the "piercing the corporate veil" doctrine that says if someone really abuses and disrespects the corporate form to screw creditors, he or she might not be able to prevent personal liability, if the creditor can show facts and circumstances that fulfill the "piercing the corporate veil" doctrine.

Very generally speaking, a corporate veil will stay intact, if the corporation complies with all corporate formalities, if the corporation is kept sufficiently distinct from the shareholders (no intermingling of funds and assets) and if the corporation is not just a plot to defraud creditors. 

Most likely, one small incident of non-compliance with corporate formalities or accidental co-mingling of personal funds with business funds if corrected in due course is unlikely to be enough to be the basis of a piercing the corporate veil claim and you should not loose sleep over it if it happened.

However, it should not happen in the first place and be avoided at all cost in order to prevent any potential claims.  Do not pay business expenses from your personal account, do not pay personal expenses with business funds; do not neglect to record corporate resolutions and meetings; do not forget to issue shares properly; do put adequate capital into your corporation; do not hide behind the corporate entity for your own personal shady dealings.  If you are a one person corporation, the formalities and separateness may seem artificial, but you have to get used to it, in order to protect your corporation's liability shield.

If in doubt what is and isn't o.k. under the doctrine, check with an attorney. 

**This post is for informational purposes only and does not constitute legal advice**

How to convert an LLC into a Corporation

There are times in the life of a business when one business form has to be converted into another.  For example, a startup may have initially decided to form an LLC in order to pass through the LLC's losses to the owners' tax returns, thereby allowing them to deduct such losses from their other non business related income.  Now the startup is seeking venture capital financing and the venture capital investors won't invest in an LLC (as is often the case).  Consequently, the business needs to convert to a corporation.  How is this accomplished?

If you are dealing with an LLC formed under the laws of Delaware,  look in Section 18-209 et seq. of the Delaware Limited Liability Company Act.  This provision allows for a merger* or consolidation** of a Delaware LLC with a Delaware corporation or a corporation formed under any foreign law.  If all of the procedures are followed, you will end up with a corporation where you used to have an LLC.

If you have an LLC formed under the laws of New York, look in Section 1001 et seq. of the New York Limited Liability Company Law.  Under these provisions, a New York LLC can also merge or consolidate with a New York corporation or a corporation formed under any foreign law.  Again, you will end up with a corporation where you used to have an LLC.

If you are considering a conversion of an LLC into a corporation, make sure to check with your accountant, attorney and/or tax adviser.  There may be important tax and other legal consequences to consider before making the move of converting an LLC into a corporation.

* A merger generally means that two business entities (A and B) become one business entity, either A or B.  If A survives, B ends and vice versa.

** A consolidation generally means that two business entities (A and B) become one new business entity, C.  A and B end.

**This post is for informational purposes only and does not constitute legal advice**

Do I have to repeat the LLC Publication if I change the Name of the LLC?

A reader asked this question in response to my post: Taking Care of the LLC Publication Requirement:

"I was hoping you could illuminate something for your readers. If a business were to file a pub requirement under one name (i.e. Acme, LLC.) but then decided that they wanted a different name and started a DBA name (i.e. Taylor Capital) would another NYS publication requirement need to be filed under the DBA name?"

Answer:  No.  The publication requirement has nothing to do with choosing to use a name for your business that is different from your legal name, i.e. choosing to "do business as".  If you want to use a different business name after you properly complied with the publication requirement for your LLC, you can do so, as long as you follow the "doing business as" rules.

P.s.  I welcome questions from readers and will try to address them in the blog where appropriate.  However, none of my posts constitutes legal advice, you cannot rely on my blog as a substitute for legal advice, and there won't be an attorney-client relationship between us.

**This post is for informational purposes only and does not constitute legal advice**

Business Entity Overview

CCH has a good overview over the business entities available to the business owner.  Be mindful, though, that choice of entity is influenced by your state laws.  For example, the overview states that corporations are usually cheaper to form than LLCs.  This is not true in New York.

Usual price tag for forming a limited liability company in New York (City): $1300, excluding legal fees.

Usual price tag for forming a business corporation (or s corporation) in New York: $195, excluding legal fees.

**This post is for informational purposes only and does not constitute legal advice**

LLCs and Derivative Actions - Tzolis v Wolff

What can a member of an LLC do if managers or members of the LLC engage in conduct that harms the LLC? 

A New York Appellate Court has held (Tzolis v Wolff, 2007 NY Slip Opinion, Appellate Division, First Department) that a member of an LLC has standing to bring a so called "derivative action." 

Derivative actions are typically brought by shareholders on behalf of a corporation to demand that the corporation take action against directors, officers, or others for actions that have harmed the corporation.  Some LLC statutes of other states also give LLC members the right to bring such actions. 

The decision of the New York court is remarkable, since the New York LLC statute does not provide for such right and the First Department declined to follow prior rulings of the Second Department which stated that members of an LLC did not have the right to bring a derivative action. 

From the decision:

We respectfully decline to follow the Second Department given 1) the historic judicial recognition of the common-law right to bring a derivative action on behalf of a corporation or a limited partnership, both of which share many of a limited liability company's characteristics; 2) the principles of statutory construction, which provide that only a clear statement of legislative intent may override the common law; 3) the fact that most states provide a statutory right to bring a derivative claim and 4) the unpersuasive rationale of those decisions which have rejected derivative claims for limited liability company members.

 

What happens if I don't file newspaper ads for my LLC?

A reader had this question in response to my post "Taking Care of the LLC Publication Requirement":

If I own an LLC just to protect the company name and I don't file the newspaper ads, is the only issue that I lose the ability to do business in NY?

Yes, if you fail to publish and file the certificate of publication in the required time frame (120 days after formation), the LLC's authority to carry on, conduct, or transact business in New York will be automatically suspended.

What does that mean in practical terms?

Nobody really knows.  The law was amended in June of 2006 and the part about "carry on, conduct, or transact business" is new.  Would have been a nice gesture by the law makers to leave us some pointers, but no such luck.

I think, at a minimum, this follows from failure to publish:

The LLC will not be able to sue in New York courts, but can still be sued.

The LLC will not be able to obtain a "certificate of good standing" from New York's Department of State.  The LLC may need such a certificate in order to get a larger loan or to participate in a major business transaction.

But, you can be sure of the following: The members (owners) of the LLC will still be protected by the limited liability shield of the LLC.

Any contract between the LLC and any other party does not become invalid, because the LLC failed to publish.

Once the LLC  takes care of the publication requirement, the law provides that the LLC regains its authority to "carry on, conduct, or transact business in New York."

End-of-Year Resolution: Clean up your Corporate House

In order to maintain its limited liability shield, a corporation must adhere to corporate formalities.  Aside from properly forming the corporation, issuing stock, appointing directors and officers, holding annual meetings of directors and shareholders, you are well advised to keep an organized and up-to-date corporate record book.  (Look her for five reasons to keep your corporate minute book up-to-date.)

While you can purchase fancy corporate binders such as the one pictured here, it is not required and you can keep all documents in whatever binder you have at hand.

Make sure that your corporate record book contains:

• The corporation’s certificate of incorporation, including any amendments thereto;

• The statement of the incorporator;

• The corporation’s bylaws, including any amendments or restatements;

• The corporate minutes of all shareholders’ and directors’ meetings;

• The share transfer ledger (also known as stock register), including the names and addresses of all shareholders, the number and class of shares held by each and the dates when they became the owners of record thereof.

To update your corporation’s record book, you need to prepare corporate minutes documenting any required shareholder or board meetings (see Section 602(a) BCL), as well as approving important transactions by the corporation since the last time the book had been updated.  Technically, it is preferable to prepare minutes before the corporation entered into an important transaction, but, let’s face it, nobody is perfect.  As long as you ratify actions at some point, you should be fine.

Many companies authorize their attorneys to keep custody of the record book in order to be sure that the record book is maintained properly.  However, if you think your time is less valuable than your lawyer’s time, do it yourself, for example with the help of this book: The Corporate Minutes Book: A Legal Guide to Taking Care of Corporate Business.