How to select the best legal entity for your new business.
By Lara Lavi ESQ
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How to start a new business – start by selecting the right legal business entity
Choosing the right legal business entity for your startup – whether you are starting a business online or you want to start a brick and mortar business – is one of the most important first steps for owning a small business. There are 7 primary structures to consider.
What are legal business entities?
First and foremost, this article does not encourage new business entrepreneurs to form their new business without the advice of a qualified business attorney. There are many online systems with stock contracts, by-laws, shareholder agreements, operating agreements etc. All of these stock documents are woefully inadequate and only a qualified business attorney can customize your documents to exactly fit your business needs.
When you were a child, you probably got by with just setting up a lemonade stand and getting right down to business. As an adult, starting a small business isn’t quite as simple and one of your first decisions will be how to structure your business. While a C corporation will probably be your best bet if you are forming a high growth, finance-intensive startup with investors and a huge worldwide roll out plan, there are seven primary business structures you generally should consider – each has its own advantages and disadvantages.
What is a C Corporation?
A C corporation (C-corp) is probably the most common business structure in the United States and has been around much longer than the others on this list. Larger companies usually favor this structure and, if you are a looking to build a Silicon Valley tech startup which raises venture capital, you should really consider a Delaware C corporation.
Advantages of C Corporations
Most venture capital firms prefer to invest in C corporations because:
IRS Code Section 1202. One of the primary reasons that venture capital companies prefer C-Corps is the potential tax advantages of Section 1202 of the IRS code that allows up to $50 million of gain on the sale of a C-Corp to be federally income free. The analysis is more involved than can be explained here, but it is only available to C-Corps. Also, large amounts of stock can be issued along with stock options to employees.
Legal precedence. C corporations have been around so long that the legal issues surrounding them are well defined. LLCs and other partnership entities are very flexible, but the legal outcomes of disputes between the owners, directors and officers are less predictable.
Income taxes can be lower. C-Corps can be more income tax-efficient than pass-through entities like LLCs and S-Corps. Corporate tax rates are lower than personal tax rates. If the intention is to keep all the earnings in the business until you sell it versus distributing the earnings to the owners, then a C-Corp is the best income tax choice.
Public companies are C-Corps. Having potentially millions of owners makes having a pass-through tax entity impractical. A C-Corp is only taxed at the entity level, pass-through entities are taxed at the owner level, and the tax responsibilities are borne by the owners.
Less administratively cumbersome. All pass-through entities have to go through the process of allocating the earnings to the owners and sending them a K1 which obligates the business owner to pay the income tax. That process can create some administrative headaches.
Limited liability. Owners are not liable for the Company’s debts.
Disadvantages of C Corporations
Conversely, some of the disadvantages of a C corporation include:
Subject to double taxation. C corporations are taxed on the corporate level and then shareholders are personally taxed if the Company issue dividends.
More administrative requirements for owning a small business. C-Corps have way way more administrative requirements such as holding a yearly shareholder meetings, election of a board of directors, formal written resolutions of the Board that document corporate actions on certain types of activities that are not required with an LLC. Failure to comply with these requirements can result in the startup owners losing the corporate liability protection from the debts of the corporation.
No deduction of business losses. You cannot deduct business losses on your personal taxes like you can with pass-through entities.
What is an S Corporation?
An S corporation is simply a tax election that corporations and LLCs can make to be taxed under Subchapter S of the IRS tax code that eliminates the double taxation problem inherent with C-Corps. In order to take advantage of this tax election, the code requires the entities to meet certain requirements.
Advantages of S Corporations
Save on self-employment taxes. Startup owners can often reduce their self-employment taxes which is a benefit only given to owners of entities taxed under Subchapter S. Self-employment taxes are over 16% of your taxable income that is paid in addition to income tax. This tax benefit is often times the reason that S-Corp status is chosen.
No double taxation. Profits and losses are passed to the shareholders without it first being taxed at the corporate level. With C-Corps, the corporation pays tax on the income and then if the earnings are distributed to the owners as dividends, the owners pay tax on the same earnings, hence the phrase “double taxation of income.”
Limited liability. Startup owners are not liable for the company’s debts.
Conversion simplicity. S-Corp status can be easily converted to C-Corp status if necessary
Disadvantages of S-Corp Status
However, venture capital firms generally don’t like S corporations because:
Limited to 100 shareholders. S corporations are limited to 100 shareholders – which can make it difficult to raise capital.
Only single class of stock. Venture capital firms generally want preferred stock which is not available with an S corporation.
Certain types of startup owners excluded. S-Corps can only be owned by US Citizens and Resident Aliens. This excludes business entities and foreigners from being owners.
Income and loss allocation difficulty. Income and loss cannot be allocated as easily because there is only one stock class and S-Corps do not permit special allocations of income and loss like an LLC does.
Must comply with corporate formalities. The owners must comply with the corporate formalities like annual meetings, board resolutions, etc or risk losing the protection against the liabilities of the corporations
What is a Limited Liability Company?
A limited liability company (LLC) is the newest business entity that provides broad tax and management flexibility. This is truly the best choice for most startup owners for companies that are small and closely held. The essence of a LLC is that the owners (aka partners) get to agree through contract on how the company will be managed. The flexibility is good; however, the novel contractual provisions makes the outcome of a potential dispute between the startup owners and managers much less predictable than the more rigid requirements that corporations have. LLC also have a lot of tax flexibility.
Advantages of LLCs
Flexible Tax Treatment. The owner(s) of LLCs can elect between four different forms of taxation. The tax flexibility is often the reason people choose LLCs over corporations. The startup owner(s) can elect to be taxed like a corporation under either Subchapter S or C. The owners can also elect to be taxed like a partnership in which the income generated by the business is passed through to the owners without the LLC paying the tax. A single owner LLC can even choose to be taxed like a sole proprietorship and include the business income and expenses on their personal tax return and eliminate the need to file a business tax return.
Limited liability. Like corporations, startup owners are not liable for the company’s debts.
No restrictions on who can be an owner. There are no requirements to be an owner of an LLC which allows foreigners and corporations to be owners in an LLC. Although the same ownership restrictions apply to the LLC if S-Corp tax status is elected, the benefits of pass-through tax treatment is available to LLCs that choose partnership tax status.
Less administrative requirements. LLCs are not required to do many corporate formalities, which means less required paperwork and no risk that they will lose the limited liability protection for failing to follow the formalities.
Increased control. The startup owners are free to agree on how they want to structure the company from an ownership and a management perspective. There can be an unlimited number of equity classes, they can have a board of directors, officers or just one manager. Almost anything is permitted whereas a corporation must have a board that must elect at least three officers, etc.
Profit Sharing. All the tax flexibility that is inherent in partnerships are available to LLCs.
Disadvantage of a LLC
An LLC can elect how it wants to be taxed, however, the flexibility that it has over corporate structure is also its biggest disadvantage:
Unpredictable legal outcomes. The biggest disadvantage of an LLC is the unpredictability that can arise if there is a dispute between the startup owners and/or the management of the company. That is often the sole reason that VCs and other don’t choose to be an LLC. Corporations require that the company follow a very strict management procedure and, as a result, the rights of owners, board members and officers have been clearly defined. If a dispute arises, the outcome is much more predictable than the freewheeling flexibility that exists with LLCs. That certainty often times far exceeds the advantages that the LLCs flexibility.
Note an LLC can elect S Corp tax status election giving the advantages of an S Corp while maintaining the LLC structure. A qualified CPA is best to explain the details of an S Corp tax status election. The IRS has a form (2553) and this is filled out and sent to the IRS for S Corp election.
What are Partnerships?
There are three types of partnerships, general partnerships, limited partnerships and limited liability partnerships (LLP).
General Partnership
In a general partnership, the owners have no liability protection against the debts of the business and both owners are responsible for 100% of the debt. A general partnership does, however, come with a few benefits not experienced with the limited liability counterparts:
Easy to create. You won’t have to file with the state to start doing business, it is just an agreement between two more people to enter into a business together.
Reduction in fees. Without filing state paperwork, a variety of fees and taxes are avoided.
Limited Partnership
Limited Partnerships require two types of partners. At least one General Partner who operates the partnership and is not given any liability protection for the debts of the business. And at least one Limited Partner, who are passive investors and they have limited liability. This structure is not very popular since the rise of the LLC which gives the general partner liability protection as well. You see it sometimes in the motion picture business where the limited partners want the general partners to be responsible for the debts, but, it is not that common.
There are other advantages of limited partnerships over General Partnership:
Limited partners have liability protection.
Limited partners are passive. Limited partners are essentially treated as investors and have no managerial control.
Limited Liability Partnerships
Limited Liability Partnerships are primarily used by professionals such as doctors, lawyers and accountants. The partnership form in most states is limited to use with professionals. The concept behind the LLP is that two doctors are partners and one doctor commits malpractice, the other doctor is not responsible to pay a malpractice judgment. Many of the professions preclude the professional from having limited liability for their malpractice and this form of partnership just shields the partners from each other while they maintain responsibility for their malpractice.
Advantages of LLPs include:
Protection from partner issues. Individual partners are protected from liability brought on by the negligence of another partner.
No double taxation. Profits and losses are filed on personal income taxes.
Fewer regulations. No need to have or participate in yearly meetings, so less paperwork is required.
Ownership flexibility. No limit on the number of owners.
Flexible managerial structure. Partners can contribute as much or as little as desired.
Disadvantages of LLPs
Limited eligibility. Some states require partners to be lawyers, doctors or other professionals.
Liability protection reduced. Not as much liability protection as LLCs and corporations.
What are Sole Proprietorships?
Sole proprietorships are one of the simplest startup business structures. In fact, many people already have a sole proprietorship without even knowing it. Simply running a business by yourself means that you are classified as a sole proprietorship.
Advantages of Sole Proprietorships
Advantages of sole proprietorships include:
Cost savings. Sole proprietorships are the simplest business structure to form.
No control issues. Since you’re the only person who owns the business, no one else has control over it.
Tax simplicity. You and your business are treated one in the same. No need to file separate business taxes.
Disadvantages of Sole Proprietorships
Venture capital firms generally don’t like sole proprietorships because:
No stock issuance. Venture capital firms want preferred stock. As a sole proprietorship, you cannot issue any type of stock.
Unlimited liability. You are fully liable for any business debts. One mistake could destroy your business and personal assets leaving the firm with a lost investment.
What are Nonprofit Corporations?
Most people think of nonprofit corporations as charities or other organizations meant to do public work. These organizations can qualify for nonprofit status with the government, but others may as well.
A nonprofit organization is simply one that is formed to benefit one of three groups. Either the general public, a certain group of people or the members of the nonprofit. Everything from charities and churches to country clubs may be eligible.
Advantages of Nonprofit Corporations
Limited liability status. Nonprofit corporations usually protect personal assets from corporate liability.
Easier to raise money. Can ask for charitable contributions from the general public. Also are more likely to get grants from the government and foundations.
Disadvantages of Nonprofit Corporations
Venture capital firms don’t like them because:
It’s in the name. Nonprofit corporations don’t typically have a main goal of profit in mind.
Increased public scrutiny. Any bad press could look bad for the organization and investors.
Expensive and lengthy to form. In addition to filing as a business and all the fees associated with it, you’ll need to apply for nonprofit status.
Increased paperwork. Nonprofit corporations have to fill out and file more paperwork than other structures.
What are Co-Ops?
A cooperative, also known as a co-op, is far from a typical startup business. It’s usually an enterprise where goods or services are produced and distributed by the members of the co-op. These same members also operate the company, but it’s geared towards their own mutual benefit.
Co-ops can be owned by those using the services, employees, and even individuals who reside inside the business (housing cooperatives). These businesses typically have a social goal in mind. Child care centers, grocery stores, credit unions and apartment complexes are just a few examples of co-ops.
Advantages of Co-ops
Incorporation option. No need to incorporate, but doing so provides protections.
No double taxation. Members are only taxed on the individual level.
Government grants. Federal, state and local grants may be available.
All members have a voice. Co-ops are literally treated as democratic organizations.
Disadvantages of Co-ops
Venture capital firms don’t like them because:
No incentive to invest more. Every co-op member gets equal say, no matter how much they invest.
Few if any benefits. Co-ops are made to benefit their members. It’s very unlikely a venture capital firm would benefit from these.
Individual funding difficult. Individual investors may also be hesitant to invest due to “one member-one vote rules.
How to start a small business – prepare and file the appropriate organizational documents
Each State in the US has a system for filing a business entity. Most allow for online filing. Again, it is best to let an attorney handle the formation and all the related paper work to assure it is done right. Concurrently, you will need an FEIN from the IRS and this again is for your attorney to secure.
To secure a business bank account, all banks require formation papers, a certificate of good standing, if you have to file a foreign registration in the state you are doing business in even though you filed the formation in Delaware, some banks require a foreign registration and some don’t and, of course, the FEIN. Every bank is different and even regionally within the same bank, the rules can be different. Best to have an attorney help you with confirming what your bank requires for your new business account.
A key to start a small business – negotiate and draft founders’ agreements
A founders’ agreement is a baseline for how your co-founder relationships will work in the future, how your company is structured, and what each owner brings to the business. It’s important no matter what type of business entity structure you have.
In most cases, this document is optional—especially if you are going directly to a shareholder agreement (INC) or operation agreement (LLC). Drawing up a founders’ agreement is best done as soon as that sparkle in your eye becomes an actual business plan: when things progress from “I have this idea” to “Let’s actually do this,” you’ll want one to be drawn up to reflect the intent of you and your founding partners.
Here are some of the reasons why having a founders’ agreement is a good idea:
Clarifies each owner’s role in the startup
Provides a structure for resolving disputes among founders
Provides clarity if and when a partner wants to enter or exit the business
Protects minority owners
Signals to investors that you have a serious startup
Lawyers and entrepreneurs understand that a founders’ agreement is an initial assessment of how things stand when the business is young. If circumstances shift slightly later on, it’s not that big of a deal. You can include procedures in this document for making necessary changes and updates. But it’s the ideal place for you and your co-founders to think through any potential problems you or your business might face—and to brainstorm solutions for the future. Also, the terms in a Founder’s Agreement can be changed for when you get to a Shareholder Agreement or Operating Agreement by mutual written consent of all the partners.
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Business plan for starting a small business