Forming a Business Entity… Which Entity is Right for Your Small Business or Start-up?
By Daniel Richardson
One of the most common questions I am asked by owners of small businesses and start-ups is whether they should form a business entity, such as a corporation or limited liability company (LLC), and, if so, which is best for them. This is a vital question for any business.
Limited liability is one of the main reasons businesses establish themselves as entities. Essentially limited liability protects the owners of the company from having any personal liability for the debts and obligations of the business other than contributions already made to the business. In other words, the owners of the business cannot be held liable if the business is sued.
Understandably, most business owners want limited liability. There are, however, many other factors to consider. These factors include tax considerations, how ownerships interests can be divided and transferred, and whether the business anticipates venture capital investments.Frequently, business owners want to form their business as a specific entity, say, a corporation, when another type of entity would be a better fit for the business. This article will give an overview of the three most common entity types, Corporations, S-Corporations, and limited liability companies that provide limited liability and address some of the questions that should be asked when deciding which business entity would be the best fit for your business.
The following is a list of the most common types of business entities in the state of California.
- Sole Proprietorship
A sole proprietorship is simply an individual running a business for profit. A sole proprietorship forms automatically when an individual begins conducting business. Sole proprietorships do not have limited liability and the profits of the business are passed directly to the owner of the business. No formation documents to start the business as a sole proprietorship.
- General Partnership
General partnerships are just like a sole proprietorship, except instead of just an individual operating the business, a general partnership is formed when two or more people operate a business for profit. Income from the business flows through to the general partners and the general partners are liable for the debts of the business.
No documentation is required to form a general partnership, but a written, signed partnership agreement defining each partner’s rights and obligations is highly recommended.
- Limited Partnership
Limited partnerships have two types of owners, general partners and limited partners. General partners have control over the operations of the business and are liable for the debts and obligations of the business. Limited partners have little or no say in the operation of the business, but have limited liability protection. This form of business entity is useful when an investor wants to invest in a business but does not want to be involved personally liable for the debts of the business.
To form a limited partnership, documentation must be filed with the state.
- Corporation (C-Corp)
The corporation is probably the most well-known business entity. A corporation provides the shareholders of the business with limited liability protection and allows for an unlimited number of shareholders. Subject to Securities and Exchange Commission restrictions, transfer of stock in the corporation can be done without affecting the corporation’s status and various types of stock can be formed. Many venture capitalists and angel investors require that a business be a C-Corp before providing any funding.
Corporations are subject to double taxation. This means that the corporation’ s income is taxed and the distributions made from the corporation’s income is taxed again when it is distributed to the shareholders.
Management of a corporation is accountable to the corporation’s board of directors who are elected by the shareholders. Corporations must also adhere to well-defined formalities such as holding regular meetings of the shareholders and board of directors, operating in accordance with the corporate bylaws, and maintaining proper records.
C-Corps are formed by filing with the secretary of state in the state of incorporation. A C-Corp must register as a foreign corporation in every state in which it actively does business.
- Small Business Corporation (S-Corp)
S-Corps are corporations, but, under the Internal Revenue Code, S-Corps have flow through taxation like a partnership rather than being taxed on the corporation’s income and taxed again when the income is distributed to the shareholders like a C-Corp. This means that rather than taxing the business’s income at the corporate level and again when it is distributed to the shareholders, the business’s income is only taxed when it is passed to the shareholders. Taxable income is allocated by each shareholder’s percentage of ownership of the S-Corp. S-Corp owners pay themselves “reasonable compensation” and must withhold FICA/FUTA taxes.
If flow-through taxation and flexibility in the transfer of stock, like a C-Corp, is desired, an S-Corp may be a good fit. Several criteria must be met to form an S-Corp: 1) there can be only up to 100 stockholders; 2) all stockholders must be either U.S citizens or residents; 3) have no more than one class of stock; and, 4) with limited exceptions, all stockholders must be individuals.
S-Corps are formed by filing with the secretary of state in the state of incorporation and then electing S-Corp status by filing Form 2553 with the IRS.
- Limited Liability Company (LLC)
An LLC is a relatively new hybrid entity that has flow through taxation and limited liability for its owners who are referred to as members. LLCs have more structural flexibility and fewer required formalities than corporations. The members can elect to have the LLC managed by the members or by managers who do not have ownership interest.
Unlike a corporation, members generally need approval from the other members before transferring an ownership interest. Equity compensation, although possible, is not as straight forward as with a corporation. Finally, obtaining capital from venture capitalists or other investors is usually more difficult because of the increased complexity in transferring ownership interests.
LLCs are formed in most states by filing articles of organization along with a filing fee with the secretary of state in the state of incorporation.
- Limited Liability Partnership (LLP)
An LLP is a partnership where one partner is not liable for another partner’s misconduct or negligence. An LLP must engage in the public practice of accounting, law, architecture, engineering, or land surveying. LLPs are formed by filing with the secretary of state.
The following considerations may help clarify which entity may be right for your business.
1. My business will only have a few owners and flow through taxation is desirable.
An LLC or S-Corp should be considered.
2. Flexibility in management and/or asset allocation is desirable for the business.
LLCs provide the greatest flexibility in structuring the business by allowing the members to decide how the business will be run without having to follow the strict formalities that corporations are mandated by law to follow.
3. My business provides services by a “licensed professional.”
If the business provides the services of a “licensed professional” as defined in the California Business and Professions Code, then the business cannot be a California LLC. Certain occupations, including lawyers, accountants, architects, and engineers may need to organize as a limited liability partnership.
4. My business plans on obtaining angel or venture capital funding.
A C-Corp would likely be the best fit under this scenario. More specifically, a Delaware C-Corp would likely be the best choice.
5. My business will have non-resident foreign owners.
The business cannot form a S-Corp since S-Corps cannot have non-resident alien owners.
6. My business will have a large number of owners.
S-Corps are limited to 100 members. LLCs and C-Corps can have unlimited ownership interests. If there are a very large number of owners, a C-Corp may be preferable because of the greater ease in transferring ownership and the existence of the entity is unaffected by the death or withdrawal of a shareholder.
7. My business will give employees stock options.
Either a C-Corp or an S-Corp should be considered.
8. My business will eventually go public.
The business should be formed as a C-Corp. Most publicly traded businesses are Delaware C-Corps.
There are many other factors to consider in forming a business entity including, but not limited to, proper documentation, securities law compliance, and the tax consequences of formation. Having experienced counsel to assist you in forming your business entity can save you from a great deal of expense and headache down the road.
ADVERTISING MATERIAL. The purpose of this article is to provide information on legal developments that may affect your business and is not to be considered advice nor does reading this content create an attorney-client relationship.
1. The preferred business entity for venture capitalists and sophisticated angel investors is the Delaware C-Corp. The topic of which state to incorporate in is outside the scope of this article and the decision should be made with the assistance of experienced counsel.
2. Certain estates and trusts described in IRC 1361(c)(2) and organizations described in IRC 1361(c)(6) are exempt from the requirement that S-Corp stockholders must be individuals.