How To Select the Perfect Entity for Your Small Business.
Starting a new business can be a scary experience. There are so many questions to be answered. How will I fund the business? Who will operate the business? Should I purchase or lease space for the business? Should I hire employees?
If you are just starting-up your business, one of the most crucial, initial questions that you should answer is what type of business entity should I choose for my business. There are a lot of entity types to choose from, including, C corporations, S corporations, LLCs, Sole Proprietorships, Partnerships, Limited Partnerships, Limited Liability Partnerships and so on. Although there is no one size fits all entity type for all businesses, it is important to figure out what type of entity is right for your business. This article will review some of the advantages and disadvantages of some of those entity types, with a special emphasis on the entities that offer limited liability protection.
Let's begin by briefly mentioning sole proprietorships and partnerships. These entities are not separate legal entities under the law and do not offer any limited liability protection for their owners. That means that the owners' personal assets (house, car, bank accounts etc.) can be fully exposed to any liabilities incurred by the business. Operating as a sole proprietorship or a general partnership, generally, is a dangerous proposition that should be avoided in most situations. Operating your business through a limited liability entity is highly recommended. When I advise “start-ups” and emerging businesses regarding entity selection, I recommend that they focus, initially, on three criteria:
Ease and Cost of Governance/Maintenance
Of course, there are other considerations, especially where the business is looking for outside funding or is considering bringing in investors in the future. However, focusing on these three characteristics provides a good starting place for most businesses. Below, I have listed the most often-selected types of limited liability entities, along with some of the more important features of each. However, one should not underestimate the importance of finding a knowledgeable attorney and accountant with whom to consult before making such a vital decision, as everyone’s situations are unique. C Corporations:
Liability Protection: C Corporations offer limited liability protection, which is important to shield your personal assets from liabilities incurred by your business.
Taxation: The major disadvantage for C Corporations is that they are “double taxed”. This means that for each dollar of revenue earned by the business, it is taxed once at the corporate level, at the corporation’s tax rate, and then again when that dollar is distributed to the corporation’s shareholders, at the individual shareholder’s tax rate. Ouch!
Ease of Governance: Another drawback of using a C Corporation is that there are many strict maintenance requirements. Most often a formal corporate board and officers must be put in place, annual meetings must be held and meeting minutes must be recorded and maintained. For smaller businesses, these rigorous requirements are often found to be overly burdensome.
Other: C Corporations are still viewed by many venture capitalists and angel investors as the most trusted type of entity, due to the fact that they have been used for a long time. For purposes of fundraising, this may be the best option for you. Additionally, if going public is in your future, a C corporation may be the choice for you.
Liability Protection: S Corporations offer the same limited liability protection offered by C Corporations.
Taxation: S Corporations are “pass through” entities, which means that revenues are not taxed at both the corporate and shareholder level, but instead “pass through” straight to the shareholders and are only taxed at the shareholder level. This can offer a meaningful advantage.
Ease of Governance: S Corporations are standard corporations that elect a special tax status with the IRS. Accordingly, the governance and maintenance requirements are similar to those of a C Corporation, which can prove to be burdensome.
Other: S Corporations can also be beneficial if you want the flexibility to set salaries for employees/owners to minimize FICA and FUTA taxes. There are some drawbacks, though, such as the inability to have multiple classes of shareholders and a limitation on the total number of shareholders that can be in the S corporation.
Limited Liability Company:
Liability Protection: Limited liability companies offer the same limited liability protection offered by C Corporations and S Corporations.
Taxation: LLCs offer the flexibility to be taxed in a variety of ways. By default, a single member LLC is taxed as a disregarded entity (like a sole proprietorship) and a multi-member LLC is taxed as a partnership. However, LLCs can also “check the box” and elect to be taxed as a C Corporation or an S Corporation, if that is more beneficial for the business.
Ease of Governance: LLCs offer great flexibility with respect to governance as well. Although it is highly recommended that a multi-member LLC have an operating agreement in place (an operating agreement is much like a partnership agreement), there is often no requirement that LLCs hold annual meetings, maintain a formal board and/or officer structure or maintain regular meeting minutes. That said, LLCs can be set up with formal boards and use an officer structure, if the members so choose; and, thus, LLCs can look just like a corporation if that is preferred. It is the flexibility and ease of governance that makes LLCs so attractive.
Other: LLCs are relatively new entities and, for that reason, are not often seen in the same light as the more traditional C Corporation by many venture capitalists, although this thinking is waning. The flexibility of the LLC often makes it the preferred choice of many start-ups and emerging businesses.
While this article outlines many of the advantages and disadvantages of the most often-selected limited liability entity types, it cannot be emphasized enough that everyone’s situation is unique and there are many factors, in addition to those listed above, to be considered. It is always recommended that a business that is just starting-up or emerging should work closely with a knowledgeable attorney and accountant so that the decisions made at the beginning of a business’ existence, which are often the most impactful decisions to be made, are made correctly. Making the correct decisions early will establish a strong foundation for success later! This blog was written by Henry Abromson at Henry Martin law.