Article by: Ross Hardeman
Clients wish to form business entities for a variety of reasons. Some clients form business entities because they intend to run an active business. Others may want to form business entities into which they intend to transfer ownership of investment real estate properties. Some individuals seek to use a business entity for the joint ownership and maintenance of boats or airplanes. One of the first questions such clients usually ask is, “Which type of business entity is right for me?”
While there are many types of business entities, the needs of most of our clients are typically met by forming a closely held business entity. Generally, a closely held business entity is one in which a majority of ownership is concentrated in the hands of five or fewer individuals. The two most popular closely held business entities are limited liability companies (LLCs) and corporations formed under Subchapter S of the Internal Revenue Code (S-Corps).
LLCs and S-Corps have several benefits in common. Most importantly, the owners of each entity are shielded from personal liability for the debts of the entity. Their liability is limited to the extent of their capital contributions to the business entity. Additionally, conducting business with an LLC or S-Corp affords the owners of the business entity more privacy than if the owners conducted business in their individual capacities.
However, there are also important distinctions between LLCs and S-Corps, beginning with basic terminology. In North Carolina, LLCs are formed by filing Articles of Organization with the Secretary of State. S-Corps are formed by filing Articles of Incorporation. The owners of S-Corps are known as “shareholders.” Shareholders own shares of stock in S-Corps. The owners of LLCs are known as “members.” Members own membership interests in LLCs. S-Corps, and other corporations, are governed by their boards of directors and managed by their officers. Generally, the affairs of LLCs are managed by “managers” appointed by the members. The key governing document of an S-Corp is its bylaws, whereas LLCs have operating agreements which set forth the rules by which the LLC operates.
Under North Carolina law, there is more flexibility in transferring S-Corp shares than flexibility in transferring LLC membership interests. Except as provided in an LLC’s operating agreement, the consent of all the members of an LLC is required to admit any person as a member. An S-Corp shareholder is generally able to more freely transfer shares of stock, though S-Corps may not have more than 100 shareholders.
There are also important distinctions between LLCs and S-Corps in the area of taxation. Each entity serves as a pass through entity for the purposes of federal income taxation. However, an LLC has flexibility in allocating profits, losses, and tax incentives among the members, whereas S-Corps do not have this flexibility among their shareholders. If the owners intend to operate an active business, S-Corps retain flexibility in allocating shareholders involved in operating the business salaries and distributions, impacting state and federal employment tax liability.
Finally, although LLCs and S-Corps afford their members and shareholders with protection against personal liability for actions taken by the companies, North Carolina law arguably provides LLCs with greater protection than S-Corps against creditors of individual members.
If a creditor obtains a monetary judgment against a member of a North Carolina LLC, the entry of a “charging order” is the exclusive remedy by which a judgment creditor of the member may satisfy the judgment from or with the judgment debtor’s ownership interest. A charging order is a court order which requires the LLC to make distributions to the judgment creditor instead of the LLC member. However, North Carolina case law indicates that the charging order entitles the judgment creditor to receive the distributions to which the judgment debtor would be entitled, thus protecting the other members. Because the charging order is the exclusive remedy available to creditors of an LLC member in his or her individual capacity, the creditor cannot seize the membership interest and exercise the rights of a member. On the other hand, judgment creditors of S-Corp shareholders may be entitled to seize a shareholder’s shares and exercise the rights of a shareholder.
There are even more considerations that go into the decision to form a business entity. We encourage those considering forming business entities to seek experienced counsel to guide them throughout the process of forming and maintaining their business entity.
Sumrell Sugg, P.A. is a regional legal firm that provides clients with first-rate services in a cost-effective manner. Whether clients are individuals, corporations, or local governments and municipalities, our firm delivers on an undeviating promise of service. For more information, visit us at www.nclawyers.com.