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Limiting Liability in your New Business

You've decided to start a new business, so the next decision is whether to proceed as a "limited liability" entity, such as a corporation or limited liability company (an "LLC").

If limiting liability is less of a concern, and keeping costs low is a critical factor, an individual can proceed as a sole proprietor; or if there are two or more of you, as a partnership. However, this is generally not recommended, since neither of these options will shelter personal assets from third party claims against the business.

To best limit liability in today's litigious environment, the most common solution is to form a corporation or an LLC.  A variety of factors will influence the choice, but here are some factors to consider.

To begin with, there are two basic options for corporations – the "C-Corporation" (standard corporation) and the "S-Corporation" (which is like a C-Corporation but includes a tax election that allows "pass-through" tax treatment, made pursuant to "Subchapter S" of the Internal Revenue Code).

S-Corp advantages: A S-Corporation’s tax election can “pass through” profits and eliminate a "double tax" – here’s how:

  1. When a C-Corporation makes profit, it is taxed at the corporate tax rate; but then, when those profits are distributed to shareholders (as dividends), each shareholder is taxed again. 
  2. Under an S-Corporation, net income and losses are passed through to the shareholders, and only taxed at each shareholder’s individual tax rate level, typically resulting in lower taxes than a C-Corporation.
  3. The “pass through” math generally operates as follows
    1. If we assume the corporate tax rate is 20% and the individual’s tax rate is 30%, then
    2. under a C-Corporation, each dollar becomes $0.56first, the $1.00 is reduced by the 20% corporate tax (and becomes $0.80); then, that $0.80 is reduced by the 30% personal tax (and becomes $0.56). 
    3. under the S-Corporation each dollar becomes $0.70…each dollar is only reduced by the 30% personal tax, so $1.00 becomes $0.70).  

S-Corporation disadvantages: To make this corporate “S” tax election, you must also accept some limitations. For example, none of your shareholders can be corporations, partnerships, non-resident alien individuals or certain types of trusts.  You cannot have more than one class of stock (but differences in voting rights in that one class of stock are allowed). You cannot have more than 100 shareholders.  Allocation of gains and losses must be made only in proportion to ownership, i.e. if you own 15% of the S-Corporation, you must be allocated 15% of the profits…no more, no less. Shareholder meetings and upkeep of corporate records are required and important, just as with a C-Corporation. 

LLC advantages: An LLC allows a number of benefits the S-Corporation does not offer.  Corporations, partnerships, trusts and nonresident alien individuals can own interests in LLCs.  There are no limits on the number of members (the LLC’s equivalent to shareholders), and there are no limits on the types of classes or series of membership.  Gains and losses can be allocated disproportionate to ownership, i.e. you can own 15% of the LLC, but receive 50% of the profits.  Also, LLCs are easier to maintain than corporations, with no required annual meetings.

LLC disadvantages: LLCs must pay a minimum annual franchise fee (just like corporations), but in some states, LLCs may also have to pay an additional graduated fee (in California, up to $11,790) based on gross revenue. This can have negative tax implications for a company, particularly on those selling expensive, but low margin, products.  Also, LLCs are not able to offer certain fringe benefits that corporations can offer.  Unlike corporations, LLCs can only offer non-qualified options; no incentive stock options.

The annual cost of maintaining any of these limited liability entities, including minimum franchise taxes, can be $1000 or more annually; however, if it keeps you from being personally liable for debts, liabilities and obligations of the business, it might be the best investment you make in your business.

If you have any questions about limiting your liability through a corporation or LLC, please contact Jay Landrum at or any of the Berliner Cohen business law attorneys.