Get Startup Smart: Choosing the Right Entity for a New Business
by Jennifer L. Villier, JD WealthCounsel, Legal Education Faculty
Choice of entity is fundamental to business planning. The best form of entity for a client’s business depends on several factors, including the client’s industry, location, and size. The decision involves both tax and non-tax considerations and must take into account long-term and short-term goals, including whether the business expects early losses or whether it may eventually go public.
When representing a startup company, business attorneys should address choice of entity with the founders. This discussion should include a review of all relevant factors to enable the client to make an informed decision. Whether business clients retain counsel before or after their entities have been formed, attorneys should discuss the options a client has for establishing or converting to the optimal form of business entity.
This article considers circumstances that may lead a new business to choose one entity over another.
Companies that anticipate a low risk of liability often operate as a sole proprietorship (when there is one owner) or a general partnership (when there are two or more owners) to minimize startup costs and administrative requirements. Sole proprietorships and general partnerships expose business owners to unlimited personal liability for business debts and liabilities.
Founders more sensitive to liability exposure may launch the business as a corporation or an LLC to achieve limited personal liability for business obligations. Note, however, that some limited liability provided by a closely-held corporation or LLC may be lost in the lending context, where lenders often require the owners to personally guarantee any loans to the company. Limited partnerships are another option. They offer limited liability to all limited partners, but require at least partner (the general partner) to be subject to unlimited liability for the entity’s debts.
S corporations and LLCs taxed as partnerships allow founders to benefit from the losses incurred by the business. That can be beneficial when the founders want the losses to pass through to their personal income tax returns in order to shelter income from other sources.
C corporations are often avoided—at least at the outset of a new business—because of “trapped losses.” Losses are said to be “trapped” inside a C corporation because of the entity’s corporate level taxation.
Rather than passing items of income and loss through to its owners, the corporation itself pays taxes. If the corporation incurs a loss, that loss can be offset against corporate income from a prior or future year, but cannot be used to offset the business owners’ personal income. Because the losses are trapped inside, a C corporation is not ideal for startups that project early losses.
In addition to the problem of trapped losses, startups sometimes avoid C corporations because of their notorious double taxation. Double taxation refers to the fact that the corporation is taxed on its income at the corporate level, and then its shareholders are taxed on the same income when it is distributed to them as dividends.
A C corporation may be a viable option if double taxation can be mitigated or avoided. There are a few ways to mitigate or avoid double taxation. One way is to simply retain corporate earnings. By retaining the income instead of distributing it to shareholders as dividends, the second layer of taxation can be avoided. This works well when the owners have income from other sources and can afford to reinvest the cash in the corporation to grow the business, but is not a good option if the owners will rely on cash flow from the corporation.
A C corporation can also mitigate or avoid double taxable by distributing its income as salary or bonus. The salary or bonus will be taxable to the recipients, but it will also be a deductible expense for the corporation. This strategy may be more effective in a corporation whose income is primarily derived from operations. If a corporation’s income mainly comes from assets or other investments, then there is greater risk of the IRS recharacterizing some of the “salary” distributions as dividends. Income splitting is another technique to minimize the effects of double taxation.
Income splitting refers to a situation in which a business owner withdraws as much of the corporate profits as he needs to support his lifestyle, but leaves the rest inside the corporation. Since C corporations and individuals are both subject to progressive tax brackets, income splitting minimizes the effects of double taxation. By taking only a portion of the corporation’s profits out as salary (a deductible expense to the corporation), and leaving the rest of the profits in the corporation for reinvestment, both the owner’s gross income and the corporation’s taxable income are reduced.
LLCs may be out of the question if the founders need to obtain funding from venture capitalists or other investors who prefer the C corporation structure. Most investors focus on their eventual exit from the company. Because C corporation stock can be sold in an IPO and is more liquid than LLC interests, many investors believe that a C corporation provides better exit opportunities. In other words, corporations are easier to “cash out of” when investors are ready. If a startup plans to seek investor funding within the first few years, the startup may choose to form a C corporation from the beginning. Converting to a C corporation post-formation can be an expensive undertaking. Nonetheless, some investors, once educated on the advantages, find LLCs acceptable if structured with various classes providing different rights. Investor preferences also vary by region.
LLCs are easy to set up and manage—there are no board meetings, bylaws, minutes, or other corporate formalities. Corporations (both C and S) are subject to corporate governance requirements and higher upfront costs than LLCs. If a pass-through entity must be converted to a C corporation for fundraising or other reasons, amending an S corporation’s certificate of incorporation and changing its tax election is much easier than converting an LLC to a C corporation.
Employee stock options, per se, are available only in the corporate form. One downside of stock options is the employee’s potential recognition of short-term capital gain upon exercise due to holding period rules. The equivalent form of equity compensation in the LLC context is a profits interest, which also has its drawbacks. For example, when profits interests are granted to employees of an LLC, the employees become owners of the LLC. As owners, rather than mere employees, they will be issued K-1s instead of W-2s, and they will be subject to self-employment tax liability. Nonetheless, both forms of equity compensation can serve to incentivize employees, and startup founders interested in offering equity compensation should consult with an experienced employee benefits or tax attorney.
LLCs are popular for their flexibility, but many startups find the cost of taking advantage of such flexibility (by drafting and adhering to complex operating agreements that fill the gaps in state law) to be prohibitive. This is particularly so with a two or more class structure or when trying to grant the equivalent of stock options to LLC employees. Capital account adjustments—required by partnership tax law—are complicated and can also be costly to incorporate into operating agreements. While state corporation laws are more rigid than the laws governing LLCs, corporate governing documents are also less flexible and therefore less costly to implement.
Business planners should be prepared to discuss with startup business clients the various entity options and how each could help or hinder achievement of tax and non-tax business objectives. C corporations are often an excellent but overlooked choice, particularly for those startups that anticipate the need for outside investment. Through proper tax planning, corporate double taxation may be reduced or eliminated. However, many startups experience operating losses in the early years, and those losses would be trapped inside the business if organized as a C corporation. LLCs often work well for startups that do not anticipate the need for outside investment and that plan to take cash out of the business. S corporations are another alternative for those startups that desire the familiarity of the corporate structure and the benefits of pass-through taxation.