WHAT IS THE BEST FORM OF ENTITY FOR MY BUSINESS?


Most entrepreneurs will quickly perceive many reasons to form a legal entity for the operation of their new business venture: they seek to shield themselves and their families from the liabilities of the business (to the greatest extent possible); they need to obtain some start-up capital and this will require an investment in the new business's equity; they are joining with one or more other partners and need to form a business entity the co-venturers can run together.

But the founders of the new business have some important decisions to make about the form of the new business entity. Should it be a corporation? "C" or "S"? Should it be a "pass-through" entity for tax purposes such as a partnership or a limited liability company (an "LLC", treated as a partnership for tax purposes)?

Partnerships
A partnership is generally presumed to exist, even without any filing or other official action, whenever two or more people get together to form a business (unless the parties form some other entity). Partnerships may be governed by explicit agreements as to the parties' rights and obligations, or by default statutory principles. In many ways the simplest form of organization, partnerships are considered "pass through" entities under tax laws. This means there is no taxation of the business at the entity level; instead, the business's income is "passed through" the entity and taxed to its owners. So long as the owners' tax rates are lower than the corporate income tax rate, there are tax savings. Further, because there is no entity-level tax, the owners avoid the problem of double taxation, where profits are taxed first at the entity level and then again upon distribution to the owners. If a new business expects to incur losses during its first year or more of operations, its owners will be able to claim those losses on their personal tax returns as well.

The down side of partnerships is that they offer the owners no limitation against liability (this summary omits discussion of Limited Partnerships and Limited Liability Partnerships, which are somewhat specialized forms of entity organization and do provide some limitations on liability). Anyone with a claim against the partnership could potentially collect from the personal assets of some or all of the owners. For this reason, most entrepreneurs and investors prefer a form of entity that offers protection from liability.

"C" Corporation
The most familiar of the liability-limiting formats is probably the corporation (sometimes referred to as a "C-corporation" after the subsection of the Internal Revenue Code ("IRC") governing its taxation), and this is also the choice of most technology start-ups looking toward institutional financing and the public markets in the short term. The corporate form offers the start-up's founders the ability to protect their personal assets from the liabilities of the business, as long as they always segregate their personal assets from those of the business and they abide by other basic rules of running a corporation.

The corporate form also allows the founders to immediately set up a capital structure that will permit them to raise money from angels and other outside investors. In the corporate format, they can sell shares of stock to investors, and they can structure classes of preferred stock with certain rights and preferences that outside investors may require. If the new business will grow quickly and its owners intend to go to the public markets, it will need to be a corporation because this is the form of entity most investors are familiar with and because certain laws and regulations limit the number of investors that may own the equity of a partnership or LLC.

Limited Liability Company
The LLC is an increasingly popular choice of entity for a new business, because it combines the liability limitation of a corporation with the potential pass-through tax advantages of a partnership. The organization and management structure of an LLC can also be less formal and are generally more flexible than those of a corporation.

On the other hand, forming as an LLC will not avoid taxes completely. California, for example, imposes a gross receipts tax on the revenues of the LLC, which may require the company to pay an additional several thousand dollars each year to the state. Some states also have restrictions on the types of businesses that may use the LLC format. You should check with your legal counsel to determine whether this form of entity is available to you.

Another disadvantage of the LLC is a degree of added complexity in managing equity interests. Administering equity participation by employees and consultants can be somewhat more complicated if extra care is not taken at the outset to establish the proper equity structure for the company. Because this extra layer of complexity can add to the costs of organization, some entrepreneurs for whom equity participation is important may choose to form as a C-corporation.

"S" Corporation
Tax advantages similar to partnerships may be found with an "S-corporation" – a corporation that submits a form to the IRS to receive special tax treatment under Subchapter S of the IRC. Tax treatment may be as favorable as, or even better than, that accorded to LLCs. The trade off for favorable tax treatment is flexibility, however, and the LLC has substantial benefits over an S-corporation that have allowed it to supplant the S-corporation as the choice of entity for many new businesses. Among other things, LLCs can have different classes of equity ownership, like common and preferred stock, with special voting, liquidation or other rights for certain investors. S-corporations are restricted to one class of ownership and may have no more than 75 owners. There are also restrictions on the types of persons and entities who may own shares of a S-corporation (for example, non-resident aliens, corporations and partnerships can not be stockholders), which can make raising money into an S-corporation difficult.

Small Business Tax Rollover: Entity Comparison
One other aspect of the tax laws that may influence form-of-entity decisionmaking is Section 1202 of the IRC. Section 1202 is a very useful provision for shareholders of emerging companies in that it permits the exclusion of up to 50% of the gain on sales of stock in certain types of C-corporations held for more than five years. By forming as a C-corporation, company founders position themselves best to take advantage of Section 1202. On the other hand, C-corporation founders lose the ability, available to the founders of S-corporations or LLCs, to deduct early losses from the business on their personal tax returns. If the founders want to be able to deduct early losses and preserve their ability to take advantage of IRC Section 1202, they might be best off forming the company as an LLC and then converting it to a C-corporation at the time of a VC or other major investment.

Summary
Numerous factors influence the type of entity that is most appropriate for any venture and only a small portion of those have been set forth here. For some entrepreneurs, the ability to grow quickly and accept investment with the greatest possible ease is paramount. For others, minimization of tax consequences or managerial flexibility may be more important. Choosing the right form of entity at the outset can save substantial money and headaches down the road. You should speak with an attorney experienced in this area prior to making any decisions.

 

 

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Niesar & Vestal LLC is a San Francisco Business Law Firm with a diverse transactional and litigation practice. Our clients include individuals, emerging businesses, government entities and publicly held companies. 

 

 

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