Written by: Bianca Lindau
One of the most common questions asked by entrepreneurs that have a new venture in mind is: what type of entity structure should I choose for my new business? This is an important question, which should be answered under careful consideration of the specific situation and the consequences that choosing one entity over another has. The type of entity structure chosen not only has legal consequences, but also influences financing opportunities, equity compensation and taxation. Below are ten key items to consider that can guide an entrepreneur seeking to find the most suitable entity.
Types of Entities
For most startup founders, the general entity structures that are commonly chosen are limited liability companies (LLCs) and corporations. An LLC is an unincorporated association that provides limited liability to its owners (called “members”). A corporation is formed under state law by the filing of articles of incorporation with the state and also provides limited liability to its owners (called “shareholders”). Two types of corporations can be distinguished; S Corporations (“S corps”) and C Corporations (“C corps”). These business structures get their names from the parts of the Internal Revenue Code they are taxed under. They differ in how they are taxed. By default, corporations are treated as a C corporation. C corps are subject to a corporate tax and thus pay taxes at the corporate level. If corporate income is distributed to shareholders as dividends, these distributions are taxed again at the individual level. Therefore, C corporations may be subject to double taxation. A corporation may elect to be treated as an S corp and instead be subjected to pass-through tax treatment like an LLC.
Entities Preferred by Outside Investors
At some point, the question of financing comes up. Most professional investors prefer C corporations. C corporations allow for multiple classes of stock, such as preferred stock and common stock. Preferred stock gives the holder superior rights over common stockholders. For example, preferred stock takes priority over common stock in liquidation proceedings.
LLCs are generally less favored by investors. Small or closely held businesses that will not seek outside investment may benefit from the ease of forming and the simple structure of an LLC. LLCs are usually member-managed, unless the members elect to have managers control the LLC, similar to a corporation’s board of directors. If members of an LLC decide to seek outside investment or if investors express interest in investing in the LLC, the LLC may have to convert to a manager-managed structure or a corporation to secure investment.
A corporation may elect S corporation status only if it meets certain requirements. The corporation must be a domestic corporation, only have certain persons as stockholders (such as U.S. citizens or residents, but not partnerships, corporations, and non-resident aliens), not have more than 100 stockholders, have only one class of stock and not be an ineligible entity type (for example, certain financial institutions and insurance companies). If the corporation no longer meets these requirements, the S election is revoked, and it will be taxed as a C corp. This could occur, for example, if an S corp takes an investment from a disqualifying stockholder, such as a venture capital fund.
The following scenarios may provide a general guide when making an entity selection:
- You are starting your business and have an investor prepared to invest in you now: If you are forming with investment from institutional investors—non-individuals and non-friends and family—you will likely be forming a C corporation.
- You are bootstrapping and it is uncertain whether you will move beyond personal investment and money from friends and family: A founder that intends to solely rely on personal finances, operating revenue, money from friends and family or small groups of individuals may elect an S corp or an LLC. If raising venture capital in the future, an LLC can be converted to a C corp and S corp status may be removed. Financial factors may weigh on the decision between an LLC and an S corporation.
- You are short on cash: An LLC may be the most appropriate choice. LLCs often cost less to initially form. Additional costs could arise if there is sufficient growth, such that the company requires conversion to a C corporation. This process allows for deferment of costs until institutional investors are willing to provide funds. Note that if the company has several members, additional costs could also arise as a well-structured operating agreement may be necessary to ensure that outside investment may be secured and a smooth conversion is achieved.
- You have surplus funds: If you have some cash to spare, you may want to consider forming a corporation and making an S election. A corporation may initially be more expensive to form than an LLC, but, you will be able to enjoy the advantages of being taxed as a pass-through entity. Later, when you take on investors, with a majority vote of shareholders, revoking the S election to be taxed as a C corporation is a simple and inexpensive process, which may be done with a single tax form.
As mentioned previously, S corporations and LLCs are taxed as “pass-through” entities. There is no entity level taxation on these. Individual owners report their share of profits or losses on their personal tax returns. Owners are merely responsible for paying taxes on their share in the taxable income the company receives. C corporations are subject to double taxation as the entity is responsible for taxes at the corporate level and the owners are responsible for taxes on distributions made to them.
The Startup’s Tax Status Over the Lifetime of the Company
An S corporation will lose its status as such if it no longer meets all of the requirements to maintain the S election and will be taxed as a C corporation. LLCs maintain their tax status unless they elect to be treated differently for tax purposes.
Taxation of Self-Employed Owners
Many founders want to work as employees of the newly formed business entity and self-employment taxes must be dealt with. In the case of C corporations, the profits of the corporations are taxed separately, and the stockholders do not pay self-employment taxes on corporate income. S corporation stockholders pay self-employment taxes only on income paid out as salary, which must be reasonable. The remaining income, paid out as profit, is only subject to income tax.
By contrast, members in an LLC that are actively engaged in the business must pay self-employment taxes. In a member-managed LLC, all members responsible for management must pay self-employment taxes, whereas in a manager-managed LLC, non-managing members do not have to pay self-employment taxes if they do not materially participate in running the business.
Treatment of Business Losses
Usually, business losses and deductions pass through to the S corp stockholders and members of an LLC and can offset income received on individual tax returns. However, losses of a C corp do not pass through to its stockholders, as the losses belong to the corporation and are claimed on the corporate tax return.
Eligibility and Number of Owners
Investors generally put money into a business in exchange for an equity stake. This has the consequence that the investor becomes an owner in the business. LLCs and C Corporations do not limit who can be an owner or the type of equity interest that may be issued. Particularly member-managed LLCs are less suited for a larger number of members, due to the potential difficulties that could arise when making collective decisions. Manager-managed LLCs and C corps are generally better suited to larger owner numbers. S corporations, as explained above, have strict limitations regarding owners. S corps are limited to 100 stockholders, a single class of stock, and must generally have individual stockholders that are U.S. citizens or residents.
Types of Ownership
Most corporations have two stock classes that are issued: preferred stock and common stock. Preferred stock provides the holder with preferential terms, rights and privileges compared to common stock holders. Generally, outside investors, for example, angel and venture capital investors, will want to receive preferred stock. As mentioned before, C corp provides the ability to issue different classes of stock.
S corporations only have one class of stock. If another stock class is issued it becomes a C corp as the S election is automatically revoked. This can easily occur whenever equity, such as stock options or warrants, are issued. Further, founders should bear in mind that venture capital investors generally only receive, and will accept, preferred stock.
An LLC does not have stock; but instead issue membership interests. LLCs can issue different classes of membership interests similar to a C corp that has common and preferred stock. The rights, preferences and privileges of the membership classes are not set forth in state filings, but instead are set forth in contractual agreements.
What Entity is Best for Allocating Equity to Employees?
Many times, startups provide the first hires with equity in the company to entice them to join the venture. C corporations and S corporations easily allow equity to be allocated to employees as incentive stock options and corporate equity incentive plans may be put in place. Providing equity stakes in LLCs is generally more difficult. Since LLC cannot issue stock, incentive stock options or traditional stock option plans cannot be issued. However, employees could be rewarded by giving them “profit interests.” Profit interests are an equity right that are based on a speculated future (increased) value of the LLCs. A tax expert should be consulted to analyze tax consequences of different equity incentives.
Incorporation in Delaware
Delaware is one of the most popular states to form an entity. It is popular because its laws regulating entities are the most advanced and flexible in the US. The Delaware Court of Chancery is a business court that has written most of the modern U.S. corporation case law, formation fees are generally low and little disclosure is required. However, Delaware may not be the best choice in every scenario. We will provide more information on choosing the best state to incorporate in a future article.
These considerations can provide general guidance when deciding what entity structure best suits your business needs. However, the process of choosing the best entity form for your business should ideally be carefully and comprehensively assessed with knowledgeable counsel, taking account of all relevant facts and circumstances.
Caldwell’s Corporate Practice provides advice tailored to our clients’ needs regarding emerging companies in the biosciences, pharmaceutical, and technology industries. We pride ourselves on our ability to assist companies at every stage of their lifecycle.
To learn more about entity formation, please contact us today.