Quick Q&A on Formation

What does it mean to be incorporated?  Incorporation, or formation, is the creation of a business entity by filing the right documents with the proper governmental authority.  For U.S. entities, incorporation is done by filing the entity’s Articles of Incorporation or Certificate of Incorporation (they are the same, but may be called different things in different states) with the secretary of state of a specific state or commonwealth.  If you want to form a limited liability company (LLC), you file a Certificate of Formation with the secretary of state.  Whether you form a corporation or an LLC, investors will usually ask where you are incorporated and request to see your charter.  For a corporation, the charter is another way of saying the Certificate/Articles of Incorporation.  For an LLC, what investors want to see is your Certificate of Formation and your Limited Liability Company Operating Agreement.  Want to know more about the differences between a corporation and an LLC?  Click here.

What is the difference between a corporation and an LLC?  Both corporations and LLCs are business entities formed under the laws of a specific state.  A corporation is an entity that has stockholders or shareholders (the words are interchangeable) and is governed by a board of directors.  Corporations are themselves individuals under the tax laws of the U.S. and therefore pay taxes on income of the corporation.  The typical governing documents of a corporation are the Charter (also called the Articles of Incorporation or Certificate of Incorporation), the Bylaws, and, sometimes, the Stockholders Agreement.

An LLC is an entity that has members (sometimes called partners) and is governed either by a manager or a managing board (sometimes called the board of directors/managers).  LLCs are typically either member managed (meaning there is a managing board) or manager-managed, meaning there is an individual or another entity that governs the LLC.  By default, an LLC is a pass-through entity for tax purposes, meaning there is no entity-level income tax paid and that the profits (and losses, depending on how the entity has been funded) pass through to each of its members on a pro-rata basis; they claim the profit (or loss) on their personal income tax returns.  An LLC may also elect to be treated as a corporation for tax purposes by filing an election with the IRS.  The typical governing document of an LLC is the Limited Liability Company Operating Agreement.

Corporations typically issue stock to their stockholders and LLCs have membership interests (often called units).  Stock can actually be in the form of physical share certificates issued to each stockholder, or they can be book-entry or non-certificated, which means records of the stock are kept by the corporation, but no actual certificates are issued.  LLC units are almost never certificated.

 

But wait! Aren’t S-corps pass-through entities?  What’s the difference between an S-corp and a C-corp?  It is possible to receive pass through tax treatment using a corporate structure (i.e., instead of an LLC).  Since pass-through treatment is a tax question, it makes sense that any choice to become a pass-through entity would be related to the tax law (and specifically the U.S. Internal Revenue Code).  When formed, every corporation is, by default, governed by Subchapter C of the Internal Revenue Code (the “Code”).  That means that, unless a corporation chooses otherwise, it will automatically be a C-corporation.  C-corporations are recognized as individuals under the tax law and pay income taxes at the corporate level.  Profit is passed to their shareholders only through dividends.  A corporation may elect to be treated as a pass-through entity under the Code by making an election under Subchapter S.  To make that election, the authorizing resolutions of the corporation should permit an S-election to be made.  Then, the corporation’s officers (or designated authorized person) submit a form to the IRS making said election.  If the election is made in the first 75 days of the corporation’s fiscal year, then it will be treated as a pass-through entity for that fiscal year—otherwise it will be treated as a C-corp until the start of the next fiscal year.  A couple of key points about an S-corp:

  • The shareholders of an S-corp have to be either individuals (actual people) who are U.S. taxpayers or a type of trust that has been authorized under the Code to be a member of an S-corp (if this is a question for you, ask your tax lawyer for more details);
  • There may be only one class of stock in an S-corp (meaning you cannot have common and preferred stock with different rights in an S-corp). You can, however, have one class of stock with the same economic rights, yet with voting and non-voting versions;
  • An S-corp may have no more than 100 stockholders; and
  • If any of the requirements to be an S-corp are not met at any time, the S-corp election is immediately considered “blown” and the corporation automatically becomes a C-corp.