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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?

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.