Selecting the right business entity is an important decision that entrepreneurs face when starting a business. When choosing a business entity, it is important to consider several factors, including liability (limited vs. personal), tax implications, complexity of formation and management, effect on ability to raise capital, and credibility in the business world.
There are several different business entities to choose from, including sole proprietorship, general partnership, limited partnership, S corporation, C corporation, Limited Liability Company (LLC), Low Profit Limited Liability Company (L3C), and Not-for-Profit Corporation. Each entity has its unique set of characteristics that can impact your business in various ways.
In this overview, we will touch on the most common business entities and the factors you should consider when choosing one.
A sole proprietorship is the simplest type of business enterprise, where an individual (or a team of spouses) carries on a business for profit. The sole proprietor has unlimited personal liability for the business and reports all income and expense items on Schedule C of their personal income tax return (form 1040). A sole proprietorship is relatively simple to start but offers no liability limitation. That means that a sole proprietor is personally responsible for any business debts and expenses.
If the business is conducted in other than the legal name of the owner, an assumed name publication should be undertaken.
A general partnership involves two or more co-owners carrying on a business for profit. All partners have unlimited personal liability for partnership debts, and the partnership files a Form 1065 for tax purposes. The partnership agreement is usually entered into but is not legally required, making this entity relatively easy to start. However, the ability to raise capital is limited, and investors prefer entities that offer limited liability.
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. This allows S corporations to avoid double taxation on the corporate income.
A Sub-chapter S Corporation offers limited liability for shareholders, even if they participate in management. S Corporations have limitations on the number and type of shareholders and have a limited ability to raise capital. For example, only one class of stock is allowed (which makes it impossible to issue preferred stock that venture capital investors require), and foreign persons cannot be shareholders.
A C Corporation offers limited liability for shareholders and is typically required for publicly traded corporations, businesses that require venture capital, or if a broad-based stock option program is utilized. C Corporations face double taxation at the corporate and shareholder levels, but this can be mitigated by paying reasonable salaries to shareholders in exchange for services rendered.
C Corporations are structured to accommodate the use of stock options and restricted stock that vests over time. LLCs are not friendly to the use of these tools. Most tech startups tend to issue stock options to keep new employees motivated to help the company succeed.
Establishing a C Corporation is beneficial to founders as well as potential investors due to Section 1202 Small Business Stock tax treatment. The special treatment provides for a method to avoid paying tax on up to $10 million of capital gains from the sale of qualifying small business stock. For that method to apply, the qualifying small business must always have been a Subchapter C corporation.
Limited Liability Company (LLC)
An LLC is a business entity that combines the limited liability of a corporation and typically has pass-through partnership tax treatment.
The formation steps for an LLC include filing articles of organization with the Secretary of State, contributing a suitable amount of capital, and adopting an operating agreement. An LLC can be managed by the members or, more often, by managers selected by the members. It can also elect officers.
The treatment of gain on the distribution of appreciated property is more favorable, and different classes of ownership are allowed, providing flexibility to provide for a priority return of capital to investors. LLCs are often used to own commercial real estate.
Absent a special election to the contrary, owners of a limited liability company are personally responsible for the income tax items associated with the LLC. In situations where there are multiple owners, the decisions related to income tax may be made by one or two owners. The remainder of the owners may be bound by those decisions and may have to report significant income on their personal tax return. Frequently the ability to deduct early-stage losses are limited to those LLC owners who participate in management.
Single Member Limited Liability Company (LLC)
A Single Member Limited Liability Company provides limited liability for the owner, frequently making it a better choice than a sole proprietorship unless the cost of formation or maintenance is a controlling factor.
From an income tax perspective, a Single Member Limited Liability Company is a disregarded entity, and all income and expenses are reported on the sole member's tax return, with no income tax return being required to be filed by the LLC.
The formation process for a Single Member Limited Liability Company is similar to a multiple-member LLC, except that the operating agreement will likely be less complex. In addition to circumstances where a sole proprietorship would be considered, a Single Member Limited Liability Company is often used by a corporation or LLC to insulate the liability associated with a subsidiary or particular line of business. Outside equity investment is only allowed if the Single Member Limited Liability Company is converted to a multi-member LLC.
Piercing the Corporate Veil
The limited liability associated with a corporation or a limited liability company can be lost if appropriate formalities are not followed. A corporation or LLC should be appropriately capitalized upon setup, annual meetings of shareholders and directors (or members and managers if an LLC) should be conducted and minutes of those meetings placed in the company records. Financial records and bank accounts separate from the personal records should also be maintained.
Common Corporate Mistakes Made By Entrepreneurs
Entrepreneurs are often faced with several pitfalls when starting a business. Some of the most common mistakes include failing to incorporate early in the company’s life, not creating a vesting schedule for founders’ stock, and failing to comply with securities laws. It is essential to avoid these mistakes to ensure the long-term success of your business.
An attorney can help you by:
- recommending the best type of business entity that would suit your goals and protect you from risks
- setting up equity incentives for your team
- keeping track of all the issued shares and stock options
- protecting your intellectual property, including patents, trademarks, and trade secrets
- establishing an orderly corporate structure that sophisticated investors prefer (venture capital investors will typically only invest in C corporations formed in the State of Delaware)
- negotiating the terms of funding rounds and investments
- compliance with securities laws
- and much more
The right business entity type for your company will depend on a variety of factors, including the size and structure of your business, tax considerations, personal liability concerns, and likely source of funding.
It is important to carefully consider your business goals and operations when deciding on the right entity type for your business. Additionally, it is important to be aware of the maintenance requirements for each entity type and ensure that you are following all necessary formalities to maintain the limited liability protection offered by the entity.
It is typically less expensive to begin the business with a good legal foundation than try to switch the entity type later in the life of the business. Typically, numerous contracts and accounts need to be assigned or closed and reopened and additional tax returns filed if a switch is made later.
By fully understanding the benefits and drawbacks of each entity type, you can make an informed choice that aligns with your goals and protects your business for the long term.