Let’s get straight to it. The S Corp is not a friend of the food and beverage establishment. If you are going to start a restaurant, the best type of entity to form is the limited liability company or the LLC.
S Corps, like LLCs, limit your liability in the event of a lawsuit. Both are also pass-through tax entities, meaning you don’t get taxed at the entity level, but only at the profit distribution level. The differences, however, are major and you need to take them into consideration when starting the process of opening a restaurant. I’ll explain some of the differences throughout this blog.
I get the reason why an S Corp is so appealing as opposed to an LLC, especially if you are a New York based restaurant. With an S Corp all you need to do is register your business as a corporation then elect to be taxed as an S Corp. On the other hand, after registering an LLC in the state of New York, the LLC must comply with the state’s publication requirement. The LLC must publish its formation in two newspapers (one weekly and the other one daily) in the county where the LLC is located. The publication must run for 6 weeks. Depending on which NYC county, it can cost you from $400.00 to $2,000.00 to publicize your LLC. The publication requirement is archaic and quite frankly, STUPID! It turns off many restaurateurs. Starting a restaurant is no small thing. If you can save a buck here and there without any serious compromise, then do it! I don’t blame you. But here’s the thing, you may be compromising your restaurant with an S Corp. Allow me to explain.
Attracting investors can be difficult with S Corps. Only natural persons, single member LLCs, and specific trusts can own shares in an S Corp. Many investors are themselves corporations, LLCs, or partnerships and like to use these corporate entities to invest and own a share in a restaurant. S Corps rules don’t allow those kinds of entities to own its stock. LLCs, however, can be owned by any entity type and natural persons. There is also no cap on the number of persons or entities to own a piece of an LLC. For S Corps, the number of shareholders is capped at 100. In the hospitality industry, LLCs are more attractive to investors.
With an LLC, profit distributions can be allocated and distributed with great flexibility. LLCs also allow for the percentage of distribution and the percentage of ownership to differ. On the other hand, the S Corp must make distributions based strictly on the percentage of ownership or number of shares that each individual owns. In other words, in an S Corp if you own 20% of the stock, you get 20% of the total distribution. In an LLC, if you own 20% of the interests you can agree to receive less or more than 20% of the distribution.
Holding Company Structure
If you have more than one restaurant, you can become a hospitality group. A hospitality group is a business formed to own a series of food & beverage establishments or hotels. The legal infrastructure best for a hospitality group is the holding company structure. A holding company is a business entity which owns one or several other entities. Those other entities are known as subsidiaries. Holding companies typically hold the subsidiaries, not operate them.
The best entity for a holding company structure in the hospitality industry is the LLC. As stated before, LLCs can be owned by other entities. If you have two LLC restaurants, you can form a third that will own the first two. Some of the benefits of forming a holding company structure are:
● Placing bulk orders at the holding company level.
● Consolidate ownership and profits.
● Simplify tax returns.
A key benefit of a holding company we’ll focus on is the sharing of profits and money between several restaurants.
One of the reasons to form a different entity for each restaurant is to protect one restaurant from any legal liability incurred by another. If one restaurant is getting sued the other one is protected because they are not operated under that same entity.
Let’s say you own two burger joints, both S Corps. One in Brooklyn and the other in Long Island. The Brooklyn spot is struggling financially but the Long Island location is thriving tremendously. Business instincts would guide you to take money from the Long Island location and financially infuse the Brooklyn location in order to sustain it while you find a way to fix its issues. Here is the problem with that strategy. One of the ways to prove that two restaurants are separate entities is to demonstrate that they have their own separate money (e.g. revenue streams, bank account). Two restaurants sharing revenue and money will blur the lines between the two entities. In this case, if the Brooklyn restaurant gets sued for a slip and fall incident and loses, the Long Island location may be financially liable as well because the court would consider both restaurants’ operations as one entity because of the sharing of money between the two restaurants. This is not ideal.
If the two restaurants were LLCs, you would form a third company, the holding company, that would own the first two restaurants. The two restaurants would become subsidiaries. All profits from the two subsidiaries would flow up to the holding company. Going back to the burger joints scenario above, the holding company can allocate its profits to the Brooklyn location for support. If a lawsuit against the Brooklyn location occurs, the Long Island location should be protected because it played no part in neither the slip and fall incident nor in the decision-making process for the Brooklyn location to receive financial assistance from the holding company. Generally, the holding company would be protected from liability as well. The holding company structure is not available to the S Corps.
The LLC is far more useful as a business tool than the S Corp. If you are starting from scratch, start with two LLCs: a holding company and a subsidiary that will operate your business. The holding company would own or hold the subsidiary. When you decide to open a new restaurant, form another subsidiary LLC with the holding company as the owner or holder. If you are concerned about costs in regard to the LLC formation and publication, reach out to us at the Beaulieu Law Firm and we can find solutions to ease the hit to your pockets.
If you are already an S Corp, you can convert into an LLC and we can assist with that. You may need a landlord’s consent to change the tenant on the lease from your S Corp to your new LLC. Contact us and we can discuss ways to get the landlord on board.
Next time, we will discuss how playing music at your restaurant without a license may get you in trouble.