Sole Proprietorships, Corporations and LLC’s: Choosing the Entity Form that is Right for you
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Florida entrepreneurs and businesses must make a decision to form the most appropriate business entity to suit their needs. Whether you are in the early stages of a start-up company, or whether you are a growing business in need of new corporate structure, there are many different considerations that will aid you in selecting the entity form that is right for your business. This article addresses several key considerations and distinctions between sole proprietorships, corporations and limited liability companies. Among those key considerations discussed are ownership requirements, equity allocation, formation and filing fees, governing documents, tax implications, liability, managerial authority, fiduciary duties, raising capital and sharing profits.
Sole proprietorships are the least complicated form of business with minimal legal formalities and easy transfer of ownership interest. The major drawback of sole proprietorships is that the owner must assume all losses and is personally liable for all of the obligations of the company. Sole proprietorships are owned by one individual. There are no equity interests issued and there are no restrictions on transfer of ownership. No formation document is required. However, if a sole proprietorship conducts business using a name other than the name of its owner, the entity must pay a $50.00 fee to register and file a fictitious name every five years with the Florida Department of State Division of Corporations and advertise the intention to register the fictitious name in the county where the principal place of business is located. Fla. Stat. § 865.09. Income derived from the business may be considered self-employment income subject to self-employment tax and filing requirements. Note that Florida businesses may be required to register with the Department of Revenue and be subject to taxes for certain business activities, and a sole proprietor should seek consultation with the Department of Revenue for full tax implications of the entity.
As previously stated, the owner is personally liable for the obligations of the business. When seeking additional capital, lenders will consider the sole proprietor’s creditworthiness, as the owner is individually liable for the business debt. All management duties belong to the sole proprietor, and there are no fiduciary duties owed. The sole proprietor receives all profit from the business.
Corporations (C-corporations and S-corporations)
Corporations are a very common business entity, and there is a well-developed body of corporate statutory and case law. This provides greater certainty than other entity forms. C-corporations and S-corporations are governed by Chapter 607, Florida Statutes, but they differ in only a few areas. The primary distinction between the two types of corporation is tax treatment. For this reason, S-corporations have substantial limitations, and they are regulated more than other business entities.
Corporations have one or more shareholders, and there are generally no restrictions on the type of owners. However, shareholders in professional corporations (CPA’s, physicians and attorneys) must be licensed or authorized to render professional services provided by the business entity. Fla. Stat. § 621.03. S-corporations may have no more than 100 shareholders, and with limited exceptions, each shareholder must be a U.S. citizen or resident. If an S-Corporation does not meet the eligibility requirements at any time, the entity automatically converts to a C-corporation. 26 USC § 1361.
Capital shares in corporations are held by one or more shareholders. C-corporation shares can be classified differently. Specifically, c-corporations may have common shares and preferred shares, which confer different rights and preferences upon the owners of the different classes of shares. Fla. Stat. § 607.0601(1). However, the corporation must have at least one class of shares that together have unlimited voting rights and at least one class of shares that together are entitled to receive the net assets of the company upon dissolution. Fla. Stat. § 607.0601(2). On the other hand, S-corporations may have only one class of shares, but differences in voting are permitted. Shares in a corporation are transferable unless the governing documents provide otherwise.
To form a corporation, the incorporators must pay a $35.00 filing fee and file articles of incorporation with the Department of State. Fla. Stat. § 607.0202. An additional fee of $35.00 is required for the designation and acceptance of the registered agent. Fla. Stat. § 607.0122(5). Each year, the corporation must file annual report. Initial bylaws are to be adopted by either the incorporators or directors, unless power is reserved to the shareholders under the articles of incorporation. Fla. Stat. § 607.0206. Shareholders have the power to make, amend or repeal the bylaws. Directors also have the same powers, unless those powers are expressly restricted under the articles or bylaws.
One of the primary distinctions between the C-corporation and S-Corporation is the tax implication. C-corporations are taxed twice: once at the corporate level and again at the shareholder level. However, S-corporations are generally taxed at the shareholder level only. S-corporations must make a timely tax election on IRS form 2553, no more than two months and 15 days after the beginning of the tax year the election is to take effect.
The benefit to incorporation is the limitation on shareholder liability. A shareholder is not personally responsible for the debts and obligation of the company; liability is limited to the obligation to the corporation full consideration for which the shares were issued or are to be issued. Fla. Stat. § 607.0622(1).
The management of a corporation is governed by a board of directors. Fla. Stat. § 607.0801(1). However, the shareholders in a corporation with fewer than 100 shareholders may agree to eliminate or restrict the board of directors. Fla. Stat. §§ 607.0801(1) and 607.0732(1). The corporation must have the officers required by the bylaws or appointed by the board according to the bylaws. Fla. Stat. § 607.08401(1). Unless otherwise provided in the articles of incorporation or the bylaws, amendments to the articles and most fundamental transactions such as merger and voluntary dissolution require majority shareholder approval. Fla. Stat. §§ 607.1002 and 607.1003.
The directors of the corporation owe fiduciary duties to carry out their responsibilities in good faith and in the best interests of the company. Fla. Stat. § 607.0830(1). Directors have wide discretion in their business judgment, and actions taken purely in the exercise of that business judgment will be given great deference by the courts. Directors have no liability for their conduct in the capacity as a director so long as they conduct themselves in accordance with the duty of care and loyalty set forth in the Florida corporation statutes. Fla. Stat. § 607.0830(5).
Corporations raise capital through issuance of equity or stock. Corporate stock can be issued by private placement or by public offering, but S-corporations must be converted to a C-corporation before initial public offering. Corporations are generally limited by the number of shares authorized the articles, and the number of authorized shares can be increased by amending the articles. Fla. Stat. §§ 607.0603 and 607.1002.
Corporations allocate profits to shareholders by making authorized distributions. Distributions to shareholders are generally dividends paid in cash from the corporation’s earnings with certain restrictions. Fla. Stat. § 607.06401. Distributions cannot be made if the corporation is unable to pay its debts in the usual course of business or if its liabilities exceed its assets. Fla. Stat. § 607.06401(3). Directors may be personally liable to the company if they assent to improper distributions. Fla. Stat. § 607.0834.
Limited Liability Companies (“LLC’s”)
LLC’s formed prior to January 1, 2014 are governed by Chapter 608, Florida Statutes. Statutory and case law is less developed than corporate statutory and case law. In an effort to create more certainty, the Florida legislature passed a new LLC act under Chapter 605, which is modelled after the revised uniform LLC act adopted by many other states. Chapter 605 governs all LLC’s formed after January 1, 2014, and it completely repeals Chapter 608 after January 1, 2015. LLC’s offer great flexibility with the benefits of partnership-like management structure and limited liability of members.
A limited liability company may have one or more members, and membership interests are held by one or members. After formation, a new member may join only with the consent of all members, unless otherwise provided by the operating agreement. Fla. Stat. § 605.0401(3). Membership interest is transferable unless restricted in the operating agreement. The transferee does not obtain management rights, but only receives the transferor’s economic rights to receive distributions. Fla. Stat. § 605.0502.
The governing documents of LLC’s are the articles of organization and the operating agreement. Certain statutory provisions cannot be modified or waived by the articles or the operating agreement. Fla. Stat. §§ 605.0201(3) and 605.0105(3). The articles of organization can only be amended by the affirmative vote of all members. Fla. Stat. §§ 605.04073(1)(d) and 605.04073(2)(e). LLC’s are formed by the filing of articles of organization with the Department of State. Fla. Stat. § 605.0201. A required fee filing fee of $100.00 for the articles and an additional fee of $25.00 is required for registration of the registered agent. Each year, the company must file an annual report.
LLC’s are taxed at the member level only, unless the company elects to be taxed as a corporation. Many LLC’s elect to be taxed at S-corporations, and the members must take care that the governance of the company meets the requirements of S-corporation status.
Similar to corporations, members and managers are not personally liable for the debts and obligations of the company. Fla. Stat. § 605.0304. However, a court can order judgment debtors to surrender all right, title and interest in a debtor’s single-member LLC to satisfy an outstanding judgment. Fla. Stat. § 605.0503.
The LLC is managed by members directly, unless the operating agreement provides for management by managers. Fla. Stat. § 605.0407. Members of a member-managed LLC have the right to participate in the management of the company with each member’s vote proportionate to that member’s percentage interest in the profits of the company. Fla. Stat. § 605.04073. Managers of a manager-managed company have equal rights in the management of the company with each member’s vote proportionate to that member’s percentage interest and the majority-in-interest of the members is required to approve actions outside the ordinary course of business. Fla. Stat. § 605.04073. Note that a manager-managed LLC is very similar to the management structure of corporations, which are governed by a board of directors.
Members or managers with management authority owe fiduciary duties of loyalty and care to the company and to the other members. Fla. Stat. § 605.04091. The fiduciary duties can be expanded and restricted subject to certain statutory limitations. Fla. Stat. § 605.0105. LLC’s raise capital through the issuance of equity membership interests and the incurrence of debt. The issuance of membership interests is usually conducted through private placement. Unlike corporations, LLC’s are limited by the preset number of shares or authorized interests, by the company may be restricted from diluting current members’ interests by provisions set forth in the operating agreement.
Unless otherwise agreed, distributions to members before dissolution must be based on the agreed upon value of the contributions of each member. Fla. Stat. § 605.0404(1). Similar to corporations, LLC’s cannot make distributions to the extent that the LLC would not be able to pay its debts in the usual course of business or if its liabilities exceed the value of its assets. Fla. Stat. § 605.0405(1). Likewise, any manager or member who consents to a wrongful distribution may be personally liable to the company. Fla. Stat. § 605.0406.
If you are considering entity formation for your business, you should consider a consultation with qualified legal counsel to determine the most appropriate entity form to suit your business needs.
Source: Choosing an Entity Comparison Chart, Practical Law State Team (2014)