StartUp Guide: Business Entity Formation--Choosing the Right Form

By: AltaClaro | Published:
Oct 09, 2018
(8 minute read)

The way a start-up organizes its business defines the scope in which it can function. A start-up can choose from one of several entity forms depending on its business needs. Forming a partnership, forming an LLC, and forming a corporation all have important consequences for the business. The most popular entity forms are limited liability companies (LLCs) and corporations. Other ways to structure a business are sole proprietorships and partnerships (including general partnerships, limited liability partnerships (LLPs) and limited partnerships (LPs)). Before advising a client on an entity form you should consider various factors such as liability, tax, and ownership implications. Here is a comparison of two of the most popular forms: corporations and LLCs:

Limited Liability Company (LLC)

Liability

An LLC provides a structure that protects members from personal liability for the company’s debts or liabilities, similar to a corporation. However, members can be made personally liable in cases of fraud or when the company fails to meet legal and reporting requirements.

Taxation

An LLC structure provides a lot of flexibility when it comes to taxation. An LLC can choose to be taxed as a pass-through entity or as a C corporation. The main benefit of being taxed as a pass-through—or flow-through—entity is avoiding “double-taxation” (i.e. being taxed at the entity level and then again on distributions of profits to the owners—in a pass-through entity, any profits “pass through” the entity to the company's members who report their share of the profits on their personal federal tax returns). However, franchise or other state or local taxes may still be levied on the LLC, negating some of this perceived benefit.

Example: an LLC in California is required to pay an $800 annual franchise tax plus a gross income fee based on a sliding scale:

Fee

California “Total Income”

$900

$250,000 or more, but less than $500,000

$2,500

$500,000 or more, but less than $1,000,000

$6,000

$1,000,000 or more, but less than $5,000,000

$11,790

$5,000,000 or more

 

Source: https://www.upcounsel.com/ca-llc-fee


Thus, for a company expecting to generate revenues in its first year of business and will not be distributing profits, a corporate structure may result in lower initial tax liability, freeing up cash that can be reinvested in the business.

Ownership

An LLC may have an unlimited number of members. Members of an LLC can be foreign nationals or other companies. However, an LLC’s ownership interest is not as freely transferable as in a corporation; a member generally needs the approval of other members before selling its interest in the LLC.

Governance

All members of an LLC may be directly involved in the company’s management. LLCs are not bound by corporate formalities such as holding ownership and regular management meetings. An LLC can also elect to be manager-managed. In such case, the members will not directly govern the company but will have the power to elect one or more managers who will be given the ultimate governing rights. This can affect the fiduciary duties of the members. For an example of this analysis under Delaware law, see: https://www.hmblaw.com/media/71174/understanding_fiduciary_obligations__the_practical_lawyer.pdf

Fundraising

LLCs are more suitable for businesses financed by a small number of individuals or corporate investors. An LLC is not an ideal entity form for companies looking to attract venture capital or pursue multiple rounds of funding. Operation of an LLC becomes unduly difficult with high number of members as it requires complex operating agreements. Additionally, LLCs may be unattractive to tax-exempt venture fund investors because their investment in a pass-through entity may produce unrelated business taxable income.


Corporation

Liability

Similar to LLCs, corporations limit the personal liability of the directors, shareholders, employees, and officers. The shareholders of a corporation are only liable up to the amount they have invested in the company. However, in certain cases of wrong doings the Courts might pierce the corporate veil and impose personal liability on company’s officers, directors or shareholders.

Taxation

Corporations are subject to entity-level taxation on profits. Additionally, If any of those profits are distributed as dividends to the shareholders, those individuals must also pay a tax on that money when they file their personal tax returns. However, the impact of double taxation is minimal for a company that expects to reinvest much of the profits back into the business.

Ownership

A corporation may have unlimited number of members subject to SEC reporting requirements on reaching a certain threshold. The ownership is freely and readily transferable without affecting the continuing existence of the business.

Governance

The shareholders/owners of the corporation are not responsible for governing the company. There is a clear demarcation of governing responsibilities. The officers manage the company and are accountable to the board of directors (Board), who in turn are answerable to the shareholders. The Board makes strategic decisions and enforces company rules. The shareholders elect the Board and approve the company's bylaws, articles of incorporation and any mergers with other companies. To ensure proper separation of management and ownership (and the limited liability it affords to shareholders) corporations are required to follow certain statutory formalities such as holding regular meetings of directors and shareholders, maintaining stock ledger books, etc.

Fundraising

Because of the transferability of shares, it is much easier for  corporations to raise capital. Venture capital funds and institutional investors prefer  corporations because of the availability of separate classes of shares, allowing for the creation of various levels of preferences, protections, and share valuations. Corporations can also lure investors with the prospect of dividends, avoiding the necessity of taking out loans and paying high interest rates in order to secure capital. Corporations are also the easiest entity form to take public for an IPO.


Variation: S corp


A variation on the standard corporate form described above (often referred to as a C-corp), is the S-corp.  An S-corp is a corporation that has made a special election with the IRS to be treated as a flow-through entity for tax purposes. In order to be eligible for this tax treatment, the S-corp must comply with certain ownership restrictions:

  • Maximum of 100 shareholders;
  • Shareholders must be individuals with limited exceptions for certain trusts, estates and exempt organizations;
  • All shareholders must be US citizens or residents.

Following is a chart that summarizes the characteristics described above:

Characteristics

LLC

C Corporation

S Corporation

Liability



Limited

Limited

Limited

Taxation

Default = pass-through but can elect to be taxed as a corp

Entity-level taxation

Pass-through Taxation

Ownership

Unlimited members

Not freely transferable

Unlimited shareholders

Freely transferable (subject to contractual and securities law restrictions)

Shareholders limited to 100

Same transferability as C corp subject to IRS requirements

Governance

All members can be directly involved in management

No corporate formalities

Can be manager-managed

Management/Officers run daily activities

Board of Directors make strategic decisions & enforce company rule

Shareholders elect Board of Directors & approve company rules

Various corporate formalities



Same governance structure and corporate formalities as C Corporations

Fundraising

Difficult to raise capital

Unattractive to venture capitals & tax-exempt venture fund investors

Suitable for small number of individual or corporate investors

Easy to raise capital

Preferred by venture capitals and institutional investors

Easy to take public

Difficult to raise capital

Unattractive to tax-exempt venture fund investors

Limited to 100 investors

 

For more information on forming corporate entities, click here.

Disclaimer: The contents of this post are intended to convey general information only and not to provide legal advice or opinions and should not be construed as, or relied upon for, legal advice.

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