The questions that invariably come up for all my start-up clients is: Do I have to form a legal entity, if yes, what kind and why? Entrepreneurs have a number of legal structures available when seeking to capitalize on a million dollar idea. Because each type of entity has distinct advantages and disadvantages, it is important to thoroughly explore your options. While there are a number of different kinds of entities, I am focusing here on sole proprietorship, the LLC, the S-Corporation and the C-Corporation.
This is the simplest legal structure. It is not even really a legal structure: you just conduct your business under your own or a business name and do not form a separate legal entity. There is no paperwork required, and there are no formal corporate housekeeping rules to follow. However, you and the business are one and the same, which means that you are responsible for all of the liabilities of the business. In addition, any business income or losses must be reported on your personal tax return.
If you want to establish a one-person business quickly and don’t foresee significant re-exposure, the sole proprietorship may be for you. I would caution you, though. The lack of formality is usually far outweighed by the risk. So I would advise you to explore other options.
Limited Liability Company (LLC)
I know, the LLC is the entity of choice among start-up now. Members of an LLC jointly own and manage the business, and share the profits/losses and any appreciation/depreciation in value of the business. An LLC is a cross between a partnership and a corporation. As in a partnership, owners enjoy pass-through tax treatment, meaning that profits and losses flow directly from the business to the individual owners. In an LLC, income and loss can be allocated disproportionately among the owners. In contrast, with an S-Corp, income and loss are assigned to each shareholder according to their pro-rata share of ownership. It is important to remember that every business has different financials, so you should consult with a tax advisor regarding your own unique situation.
Like a corporation, an LLC is a separate legal entity that can own assets, sue and be sued. It provides limited liability to its owners, which means your personal assets are shielded from court judgments and debt collectors. However, an LLC may not provide owners with 100% protection from personal liability, especially if fraud or misrepresentation has occurred. LLCs must also follow business formalities, such as registering with the state and adopting an operating agreement. Still, these tasks are still simpler than the requirements for forming a corporation.
If you are looking for a low-key, flexible, informal solution with pass-through tax structure, an LLC may be a good option. However, if you plan to seek capital from outside investors, such as venture capitalists, you likely need a more rigid business structure.
A C-Corp is a distinct legal entity, with an existence apart from its owners. It is the most complex and costly business structure, primarily because it requires the most corporate housekeeping and record keeping obligations. However, it also has several key advantages. Most notably, it is not a pass-through entity, so it is taxed separately. In fact, C-Corps have their own tax brackets, which is commonly lower than individual tax rates. Owners are only liable for taxes on profits they receive in the form of salaries, bonuses, and dividends. Anyone can own shares in a C-Corp and you can create different classes of stock, allowing owners to have varying shares in terms of voting, profits and losses, etc.
C-Corps are the preferred business structure for companies that see fundraising in their near future, whether through seed rounds or from VCs.
As a draw-back, any corporate structure, including the C Corp involves formalities and compliance obligations, which can be burdensome for people just starting out, ie: may be infra-structure-deprived. If you incorporate as a corporation, you need to set up a board of directors, file annual reports and other business reports, hold shareholder’s meetings, keep records of your meeting minutes, and generally as a matter of corporate law operate at a higher level of compliance than your business might need or want to deal with. With the LLC, this isn’t the case. LLCs just use an informal operating agreement.
The S-Corp is a variation on the corporation. So most of what I said above for C-Corps (other than tax treatment) applies to them as well. An S-Corp is typically chosen for the way taxes are treated — like the LLC, the S-Corp is a pass-through entity with profits and losses flowing directly through the corporate entity to the individual shareholders. S corporations must follow certain requirements: the number of investors must be limited to 100 and all investors must be individuals and legal residents of the United States..
The S-Corp is preferable when a startup expects to make a profit soon after incorporation and most of that profit will be distributed to the shareholders as a dividend. All shareholders will be taxed on the profits individually. If you intend to reinvest profits back into the company, you should consider a C-Corp.
If you desire pass-through tax treatment and are ok with its limitations, you may want to explore an S-Corp. You can also always change your mind and convert the business to a C-Corp later on.
These are the highlights and should give you something to start with. Needless to say, do consult an accountant and/or lawyer before you take the first step. As always, if you have questions or comments, please call, e-mail or tweet me @Bettina Eckerle.
Eckerle Law offers legal advice in a variety of transactional and regulatory matters and serves companies’ plenary business law needs. Its founder, Bettina Eckerle, is a veteran of Debevoise & Plimpton and Wachtell, Lipton, Rosen & Katz. She also served as the General Counsel of two companies en route to IPO. Please visit the Eckerle Law website for more details.