July 15, 2020
Coming up with an innovative new idea or a better way to do something someone else is doing is so exciting. In recent decades start-ups have been sprouting up all over the place and in all industries. It’s really a great time to be a creative entrepreneur.
As much work as it is putting your ideas together, bringing various team members on board, and securing funding, it’s also really important to think about your company’s legal structure early on. From the very start, you will likely have partners and deals to worry about, so you want to quickly and efficiently separate yourself as the individual from the business itself. This will enable the company to be the entity that signs onto all the contracts and deals, and hires new employees, not you personally.
When you start looking into the options available to you, you’ll see that there are quite a few, so you might get overwhelmed as someone maybe newer to business. Terms like liability protection ,pass through, and double taxation may sound daunting at first, but don’t worry, we’ll guide you through this terminology and present you with the options to help you decide what’s best for your company’s future.
The two most basic options are sole proprietorship and partnership. While these may be good in some situations, they generally aren’t recommended for startups. The main reason why we caution against them is because they don’t offer you personal protection from liability. This means if you take on debt or in the event of a lawsuit, you personally can be on the hook and not just your company.
For this reason, we’re going to guide you through the two other types of business entities: LLCs and Corporations. We’ll go into the definitions and some things to consider that will help you choose the best option.
As with all big business decisions like this, we encourage you to consult with your financial and legal professionals who will be able to advise you on the best options for your particular startup’s situation.
Definitions
Before we get too deep into the “what’s better discussion” let’s make sure we all understand what we’re talking about here with some clear definitions of terms.
LLC
LLCs are “limited liability companies” and, unsurprisingly, they limit your personal liability. We discussed liability in relation to sole proprietorships and partnership above, so this is the key aspect that is different. By and large, LLCs provide you with protection of your personal assets—your bank account, house, or car—should a creditor call in unpaid loans or should your business get sued. If your business should go under and you have outstanding debts, with an LLC or corporation, you wouldn’t personally have to absorb the company debts, whereas with a partnership or sole proprietorship, you would have this obligation.
LLCs are relatively simple to set up, compared to corporations, meaning they require less paperwork, have fewer regulations, and will cost less to set up and maintain. With them being simpler to establish, that means you’ll spend less time with legal counsel which will also save you money in that regard.
The steps to set up an LLC are fairly straightforward, but do vary from state to state. So do make sure to look up the particularities for where you plan to set up shop. Typically, you will follow these steps:
Pick a name (this cannot be the same as a pre-existing entity in your state, so check your states’ Secretary of State website for a business entity search function)
Choose a registered agent
File your Articles of Organization with the state
Draft an Operating Agreement (not required in most states by law, but highly recommended regardless)
Register for an EIN with the IRS
With regard to taxation, LLCs offer a lot of flexibility. They default to the taxation of sole proprietorships or partnerships (depending on whether you have one sole proprietor or multiple owners), which involves you (and your partners) just paying the income as personal income tax on your (and their) own personal tax return. This is called “pass through” taxation. However, the key word here is “default.” When you form an LLC you can choose to have it taxed as an Corporation (more specifically, an S-Corp or a C-Corp).
With that in mind, let’s jump into the definitions of corporations.
Corporations
A corporation is a legal entity that sells parts of itself to its business owners (shareholders) and does not pass on any legal or tax liability to said board of directors, just like with an LLC. The process for setting one up is much more difficult as is operating one.
Like the LLC’s Article of Organization, a corporation needs Articles of Incorporation to be filed with the state. Further, the corporate Bylaws serve as the Operating Agreement and are required by law. These are generally more complex to draft and will need proper legal counsel.
Further, there are many filing requirements for corporations than must be kept up regularly, and viewable by stockholders upon request including:
Annual reports
Tax returns
Business accounts
Meeting Records
Licenses
See, e.g., Cal. Corp. Code § 1500; Del C. § 220; NRS 78.105; Tex. Bus. Code § 3.151; W.S. 17-16-1601.
Corporations are required to nominate and elect board members, hold annual meetings of shareholders, and take minutes of all proceedings. There is a lot more oversight and many more regulations that govern corporations.
When it comes to taxation, there are two distinct classes of corporations: C-corps and S-corps.
C Corporations
C-Corps are your standard corporations and they have the burden of double taxation. What this means is the company first pays a corporate tax rate on profits and then the employees also pay tax on their taxable income from salary and dividends. For a lot of small businesses owners, this is a huge disadvantage.
S Corporations
In order to help promote small businesses, Congress designated a new corporate business entity: the S-corp. While still a corporation in most other regards, S-Corps are taxed similarly to LLCs with “pass through” taxation that eliminates the burden of the additional corporate tax.
However, as good as that may sound there are some drawbacks to S-Corps imposed by the Internal Revenue Code and posted on the IRS website:
S-Corps are not allowed to have more than 100 shareholders
You can only operate domestically in the US
Only US citizens and legal residents may own shares of stock
You’re limited to one class of stocks
Which Business Structure is Best for Startups?
The answer to this is really going to depend on your situation and goals as a business. Here are some of the main points to consider when weighing your options:
Investors
Since you’re likely still in the early stages of your new business if you haven’t settled on a corporate structure yet, you’re likely going to need to think about how you’re going to raise capital in the future. You want to keep in mind that investors are not going to consider forming an LLC or S-Corps in most cases. C-Corps are structured for investment and stock by nature and without the restrictions of S-Corps. LLCs can technically distribute equity, however, it needs to be structured into the Operating Agreement in a particular way.
Overall, it’s much less likely to get venture capitalists to invest in your startup if you’re anything but a C-Corp.
Long-term Profits
C-Corps have a special tax benefit that is called the Qualified Small Business Stock rule that allows stockholders to be exempt from taxation if there is a significant increase in the value. Basically, if you think you’ll grow really big in the next few years, the amount you’ll save as an S-Corp or LLC with tax advantages will pale in comparison to what you could save long-term with this tax treatment.
There are several types of business, however, that are exempted from this benefit including: health, law, accounting, performing arts, farming, or hotel operators, to name a few.
Going public
If you plan to have an IPO (Initial Public Offering) at some point down the line, you’re going to want to be a C-Corp. As we’ve mentioned above, S-Corps have limitations on who can own stock, what kind of stock you can have, and how many owners there can be. If you’re going public, these limitations simply won’t work.
Startup costs
If you’re starting your company with personal funds with your founders and you just want to get up and running as quickly as possible, then you’ll want to go with an LLC. This will enable you to have the legal protection you need, while keeping your filing and legal fees low. If you think you will be ok initially without outside investors then this is a good way to keep your costs low and focus on building a great product or service, and finding your dream team.
Summary
Now that we’ve introduced you to the various options available, we hope you are better equipped to make an important decision. We’ll reiterate the importance of consulting a lawyer, no matter your choice, as they will be able to best advise you on what will work best for your business goals.
Keep in mind no matter what you choose, it’s not set in stone. If you opt for the lower cost, more efficient LLC to get you started, down the road you can convert your company to a C-Corp, get investors or go public. Sure, you’ll have to spend a bit more on restructuring than if you immediately started as a corporation, but many companies have transitioned successfully.
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