Some of the questions I get asked by my start-up clients are perennial in nature, with the most common being: Do I have to form a legal entity, and if so, what kind and why?
Entrepreneurs have a number of legal structures available when seeking to capitalize on a million-dollar idea. Each type of entity has distinct advantages and disadvantages that I discuss below, and the decision should be tailored to your individual situation. The choice will impact the amount of tax you pay, the amount of paperwork you are required to do, the personal liability you face, and your fundraising activities. While there are a number of different kinds of entities, I am focusing here on the most common—the sole proprietorship, the LLC, the S-Corporation and the C-Corporation.
This is the simplest solution. 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. Obviously there is no paperwork required for formation etc., and there are no formal corporate housekeeping rules to follow. However, you and the business are one and the same, which means that you individually are a party to all the contracts of the business and are responsible for all of its liabilities. Also, sole proprietorships may find it difficult to raise money from banks and other sources. 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 exposure, the sole proprietorship may be for you. I would caution you, though: The lack of formality is usually far outweighed by the risk—see above.
Limited Liability Company (LLC)
The LLC is the entity of choice for many start-ups now. Members of an LLC jointly own and manage the business, sharing the profits/losses as well as any appreciation/depreciation in the 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 without separate taxation of the LLC, meaning that profits and losses flow directly from the business to the individual owners, and there is no double tax—and, as in a corporation, the members are shielded from personal liability. Unlike an S- or C-Corp, in which income and losses are assigned to each shareholder according to their ownership percentages, in an LLC income and loss can be allocated disproportionately among the members.
Like a corporation, an LLC is a separate legal entity that can own assets, sue, and be sued. LLCs must also follow some business formalities, such as registering with the state(s) they conduct business in and adopting an operating agreement. Still, these tasks are simpler than the requirements of choosing a corporation. Moreover, employee equity incentive compensation can be structured as “profits interests” which, when structured properly, are advantageous for employees from a tax perspective. The drawback is that employees are usually accustomed to stock options, and they will also have to file Schedule K-1s as members of the LLC.
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 corporation. In my experience, VCs require C-Corps.
A C-Corp is also a distinct legal entity, with an existence apart from its owners. It requires the most corporate house- and record-keeping obligations. It is also not a pass-through entity, so the business is taxed separately and creates the issue of double-taxation both on the corporate level and on the stockholder level for dividends paid to stockholders. Work with an accountant to structure payments to stockholders in a tax-efficient manner. For an advantage, you can create different classes of stock, allowing owners to have varying shares in terms of voting, profits and losses, etc. Also, you can grant options to employees as incentive compensation—by far the most common form of incentive compensation.
As a drawback, any corporate structure, including the C-Corp, involves formalities and compliance obligations which can be burdensome for people just starting out, i.e., may be infrastructure-deprived. If you incorporate as a corporation, you need to set up a board of directors, hold board and shareholder meetings, keep records of your meetings, 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 to the same degree.
Important to point out: C-Corps are the preferred business structure for companies that see fundraising on the horizon. Of course there is always the option to change the structure down the line, but that would require more paperwork and may have tax implications.
The S-Corp is a variation on the corporation. That means most of what I said above for C-Corps (other than tax treatment) applies to it as well. An S-Corp is typically chosen for the way it is treated by the tax laws: 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 without separate tax at the S-Corp level. S-Corps 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 when most of that profit will be distributed to the shareholders as a dividend. All stockholders will be taxed on the profits individually. If you intend to keep the profits in 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.
To sum it all up: the choice is yours, there is no right or wrong answer. However, the structure you choose should be carefully considered and tailored to your unique, individual situation with your accountant and business lawyer.