A critical decision for any start-up business is choosing the appropriate and most beneficial legal entity in which to operate. If chosen properly, the characteristics of the entity can serve as a valuable foundation in helping a business achieve its goals. If chosen improperly, it can hinder a business's growth and expose its founders to unexpected personal liability. This article highlights some of the important distinctions between the most commonly used business entities.
When choosing a business entity, there are numerous considerations. This article focuses on three of the primary ones: limitation of liability; impact on taxation; and, flexibility to raise capital for future growth. The starting point of any analysis should be the recognition of the fundamental distinction between incorporated and unincorporated businesses: the limitation of personal liability. Specifically, owners of an unincorporated business may find themselves personally liable for the debts and obligations of the business whereas owners of an incorporated business, absent certain misconduct, will not be held responsible for debts of the business. Although the inability of an unincorporated entity to limit personal liability is a significant drawback for many, the unincorporated form remains popular for certain start-ups because of its managerial flexibility, simplified tax accounting and reduced administrative costs.
UNINCORPORATED ENTITIES
Sole Proprietorship
The most basic form of unincorporated business is the sole proprietorship. As its name suggests, a sole proprietorship is owned by one individual who retains complete managerial control over the business. The unfettered control offered by this entity is often crucial to getting an early-stage idea off the ground.
As with all unincorporated businesses, the owner is personally liable for the debts of the business. While this may seem risky, not all businesses engage in activities that subject them to an inordinately high level of risk. Furthermore, a business owner's personal umbrella policy may insure against some of the risks associated with operating a sole proprietorship. Despite these considerations, before beginning business operations, it is prudent to consult an experienced business attorney to identify the risks a particular business may face and what level of insurance coverage may be necessary.
From a tax standpoint, sole proprietorships are appealing because of their simplicity. This simplicity comes from the fact that the profits and losses generated by a sole proprietorship are reported on the owner's personal federal and state tax returns (this is frequently referred to as "pass-through" taxation). As a result, in the event of business losses, the owner of a sole proprietorship may use them to offset income earned from other sources. The owner will, however, be responsible for self-employment taxes and making quarterly estimated tax payments on his or her income to the IRS.
The growth of a business, although difficult to anticipate, should also be considered when choosing an entity. The prospects of raising significant capital as a sole proprietorship are not strong. Because the owner retains absolute managerial control, outside investors have limited ability to oversee and protect their investment and, therefore, are reluctant to lend funds. As a result, sole proprietors usually rely on his or her personal resources or those of close family and friends.
Partnerships
A partnership exists when two or more people operate a business for profit. While partnerships have been in decline since the introduction of the Limited Liability Company (LLC) in 1977, they are still a commonly used business entity. Partnerships usually exist in one of two forms, general partnerships or limited partnerships. General partnerships and limited partnerships share many of the same advantages as sole proprietorships, most notably the simplicity that comes with "pass through" taxation.
The most significant distinction between a general and limited partnership is the apportionment of control and liability. In a general partnership, the partners are jointly liable for the debts of the business and share managerial control. General partners are authorized to enter into binding contracts on behalf of the partnership and can be held vicariously liable for actions of other partners. As a result, a high level of trust between partners is essential. Limited partnerships are comprised of both general and limited partners. General partners are personally liable for the debts of the business and maintain managerial control. Limited partners are investors only and their liability for the debts of the business is limited to the extent of the money they have contributed. In return for limited liability, limited partners do not have any managerial control over the business.
Many people assume a partnership is always formed by an agreement; however, a partnership may arise, absent an agreement, by operation of law. In these situations, the partnership is governed by the laws of the jurisdiction in which it is operating, which may or may not conform the expectations of the partners. Therefore, the importance of a having partnership agreement in place before beginning business operations cannot be understated. A carefully drafted agreement can, among other things, prevent future disputes concerning a partner's rights and/or obligations to the businesses and assist in a smooth transition should a partner become unable or willing to continue on in the business.
INCORPORATED ENTITIES
An incorporated business is a legally recognized entity that has rights, privileges, and liabilities distinct from those of its members. As a result, the obligations of an incorporated business, absent corporate misconduct, remain those of the business and do not become those of its members. To incorporate, a business must file Articles of Incorporation with the state in which it operates. Once the corporation has been certified by the state, the business must be certain to adhere to its by-laws (hold annual meeting, keep meeting minutes, maintain accurate financial records and hold shareholder votes on certain corporation actions). Since incorporated businesses are generally more complex and face greater accounting and reporting requirements than unincorporated businesses, they typically encounter higher professional and administrative expenses. Two common types of corporations are the C Corporation and the S Corporation.
C Corporation
Companies that do not elect S Corporation Status with the Internal Revenue Service, as discussed below, are referred to as C Corporations. Most publicly traded companies in the U.S. are C Corporations. C Corporations have the ability to issues multiple classes of stock and, as a result, are excellent entities for businesses which anticipate the need to raise a significant amount of capital. For example, a C Corporation conducting multiple rounds of financing has the ability to offer several classes of preferred stock. This is highly appealing to venture capitalists as it allows them to protect their investment and gain some control over the direction of the business. Additionally, C Corporations are not restricted in the number of shares they can issue and their shareholders need not be U.S. citizens or residents. Thus, if a C Corporation is publicly traded there will be an extremely large market for its shares.
From a tax perspective, C Corporations present some advantages and disadvantages. An attractive feature of the C Corporation is that it may, subject to certain restrictions, deduct the costs of employee benefit programs, such as healthcare, as a business expense. C Corporations are, however, subject to what is sometimes referred to as "double taxation." The first level of taxation occurs when the corporation, as an entity, is taxed on its profits. The second level of taxation occurs when the corporation makes distributions to its shareholders, who must also pay tax on the money they receive.
Management responsibility for a C Corporation rests with its Board of Directors and its officers. Typically, the Articles of Incorporation will name the first Board of Directors. After their initial term expires, the Board is elected by the shareholders. The Board is the locus of management authority and responsible for the direction the corporation as a whole. To execute their vision, the Board appoints Officers who are responsible for the day-to-day operations of the corporation.
S Corporation
S Corporations are creations of the Internal Revenue Code. A business wishing to receive S Corporation status must elect, within a certain timeframe, to be taxed under Subchapter S, Chapter 1 of the tax code. S Corporations may only issue only one class of stock and must have under one-hundred shareholders, all of whom are U.S. citizens or residents (with exceptions for certain trusts, estates and charitable organizations). The S Corporation provides the liability protection associated with the incorporated form but allows for the tax benefits typically afforded to unincorporated businesses. Specifically, an S Corporation is not a separate taxable entity for federal, and most state, income tax purposes. Instead, profits and losses of an S Corporation are divided pro rata among the shareholders and "passed through" to their personal returns.
S Corporations will have greater access to capital than unincorporated businesses but will be limited by the fact that it can only offer one class of stock. Experienced investors and venture capitalists want to protect their investment and gain a measure of influence over the operations of the business so they often require preferred shares.
Management of an S Corporation conforms to the same management principles of a C Corporation, as discussed above.
LIMITED LIABILITY COMPANY
The Limited Liability Company (LLC) is a hybrid entity that combines the most attractive aspects of a partnership and an incorporated business. Specifically, an LLC protects the owners from personal liability while allowing business profits and losses to be "passed through" to their personal returns.
While an LLC appears similar to an S Corporation, an LLC may have an unlimited number of shareholders. In an LLC, shareholders are referred to as "members" and their rights and obligations are defined in an operating agreement. The operating agreement will also indicate whether the LLC is "member-managed" or "manager-managed." Member-managed LLCs grant management rights to all of their members, similar to a partnership. Many, but not all, smaller businesses choose this form. Larger businesses, or those with members that have limited management experience, may choose to operate as a manager-managed LLC where managerial authority will rest with specific members.
As previously mentioned, LLCs enjoy similar tax treatment to unincorporated businesses and S Corporations as profits and losses "pass though" to the members in proportion to their ownership. LLC members are required to pay self-employment taxes, which are calculated as a percentage of profits. In contrast, self-employment taxes in an S Corporation are calculated based on salary, not profit. A final aspect of LLCs to consider is the fact that the cost of providing employee benefits is not tax deductible as it would be with a C Corporation.
LLCs can present some problems when members need to seek additional capital. Venture capitalists tend to be reluctant to invest in an LLC because altering a pre-existing operating agreement to protect their investment frequently takes significant effort. Professional investors would much rather deal with an S or C Corporation formed in a familiar jurisdiction, such as Delaware. In anticipation of this, many LLCs are formed with the understanding or agreement that in the event venture financing becomes necessary to continue business operations, it will convert to an S or C Corporation.
CONCLUSION
As you have just read, there are numerous factors that should be considered when choosing a business entity. All businesses will have unique needs and goals, and choosing the correct entity at the outset will allow those goals to be met with the fewest complications. An experienced business attorney can help a new business owner choose the right entity and maximize its chances for success.
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