How to Choose an Entity for your Business
Businesses can operate under a variety of entity types. No form of entity is right for all businesses—all have merits and demerits. The form of entity that is appropriate for your business will depend upon which of these advantages and disadvantages has the greatest impact on your business6 min read
2. Limited Liability Company
3. Subchapter S Corporation
4. C Corporation
5. B Corporation
6. Choosing an Entity
This summary outlines some of the considerations relating to the decision about what form you may want to use when starting your business. These should be discussed in more detail with an attorney and your accountant before you make a selection; however, this will introduce you to some of the pros and cons involved in making your decision.
Types of Entities
There are several forms of business entities available—limited liability companies, C corporations, S corporations, B corporations, sole proprietorships, general partnerships, and limited liability partnerships. However, unless unique state law considerations are present, only a few of these forms provide features that are attractive to most startup businesses. These are limited liability companies, C corporations, B Corporations, and S corporations.
If you are operating a business and fail to formally create an entity, your business will default to either a general partnership if there are multiple owners or a sole proprietorship if there is one owner. Neither structure protects your personal assets from creditors and it is not usually recommended to operate your business this way because the risk does not outweigh any reward. Therefore, you should consider creating a formal entity like an LLC or corporation before starting your business.
Limited Liability Company
LLCs are the most popular type of entity for small businesses that do not have plans to receive outside investment from angel or venture groups.
An LLC is an entity separate from its owners and its ownership can be divided similarly to a corporation. As a separate entity, the LLC is responsible for its debts and liabilities, and its members have no personal liability. If the business fails or is subject to claims that exceed the value of its assets, the members may lose their investment in the LLC, but their personal assets are ordinarily safe.
An LLC provides the same income tax treatment as a general partnership. However, single-member LLCs are typically considered a “disregarded entity” for tax purposes. In either situation, all income or loss of an LLC is reported on its members’ individual income tax returns regardless of whether that income is retained in the business. This is known as “pass-through” taxation. If there is more than one member, the income or loss is divided between them. If an LLC incurs losses, its members are in a position to offset these losses against other income. However, keep in mind that in some circumstances there may be limits on using losses to offset other income for LLC owners who are not actively engaged in the business.
The primary disadvantage of an LLC is that it is not the preferred structure for outside investors of a startup company. If you intend to seek outside funding for your business whether through venture capitalists, angel investors, or public offerings, you would likely want to avoid the LLC structure. Although some angel investors will invest in LLCs, ordinarily, investors will want your startup to convert to a Delaware corporation.
An LLC is created by filing articles of organization with a state and many states provide online filing. Some states require annual reports to be filed to maintain the LLC’s existence. To form an LLC you will also need an Operating Agreement, which governs the operations of the company. This can be a fairly simple document for a single owner LLC or more complex for multi-member companies but is required to maintain business formalities and maintain protection against personal liability.
It is possible to create an LLC that elects to be treated as an S corporation for tax purposes. Such an entity combines some of the best features of both types of entities—its management structure can be informal and flexible like an LLC while it takes advantage of the employment tax benefits of an S corporation.
Subchapter S Corporation
An S corporation is a tax election. The creation of an S corporation involves first creating a C Corporation or LLC with the state and then filing a Form 2553 election as an S corporation with the IRS. S corporations have advantages and disadvantages similar to those of an LLC. Both S corporations and LLCs can have one or more owners, both are responsible for their own debts and liabilities so that owners enjoy limited liability, and profits and losses both pass through and are reported on the owners’ income tax returns.
Not every corporation or LLC can elect to be taxed as an S corporation. Several requirements must be met and these requirements offer restrictions that may not be attractive to every business. To qualify for S corporation status, the corporation must meet the following requirements: (1) Be a domestic corporation; (2) Have only allowable shareholders (these may be individuals, certain trusts, and estates but may not be partnerships, corporations, or non-resident alien shareholders); (3) Have no more than 100 shareholders; (4) Have only one class of stock; and (5) Cannot be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Thus, S corporations are limited to closely-held businesses, and venture capital firms are usually precluded from investing in S corporations because they are not considered “allowable shareholders.” Since S corporations can only have one class of stock, they offer little flexibility with capital structure. However, an S corporation can convert to a C Corporation if need be.
The major attribute that distinguishes S corporations from LLCs is the treatment of employment taxes. Wages and salaries paid to employees by an S corporation are subject to FICA tax. But the income of an S corporation itself is not subject to employment taxes at the time it is earned. And, dividends paid out of an S corporation’s current or accumulated income are typically not subject to these taxes.
C corporations are the most common entity type for startup companies who plan to seek investment from angel and venture capital groups. They provide limited liability for their owners and are comparable to LLCs and S corporations in terms of their costs of creation and maintenance.
The major advantage of a C corporation is that it is the preferred structure for outside investors and public offerings. Thus, it is easier to engage in equity and debt financing for corporations. For startup companies, Delaware is the most popular state to form a corporation.
Another advantage that C corporations offer for new businesses that are often overlooked is lower tax rates on the first $50,000 of annual income versus LLCs. Furthermore, only employee salaries are subject to employment taxes whereas all income earned in an LLC is subject to self-employment tax. And, a C corporation can also retain profits in the business without those amounts being taxed to its shareholders.
The major disadvantage of C corporations is that its income or loss is taxable to the corporation and does not pass through to its shareholders. As a result, shareholders cannot use a C corporation’s startup or other losses to apply against other income. Moreover, C corporation income can be taxed twice—once at the corporate level when it is earned and again at the shareholder level when distributed as dividends or when a shareholder sells stock at a gain attributable to the corporation’s accumulation or investment of its income. However, double taxation can sometimes be avoided during stock sales and mergers.
For those entrepreneurs whose goals are not solely aligned with the aim of investor return, the B Corp may be just the entity for you. Think of it as a blend of for-profit and not-for-profit models. By law, B Corps are managed in a manner that balances the stockholders' financial interests, with the best interests of those materially affected by the corporation's conduct (i.e. environmentally responsible), or the public benefits identified as its overall mission. This structure allows a company to protect its mission over time. Since, generally, a two-thirds super-majority shareholder vote is required to remove the stated purpose of a B Corp, a company can make decisions that foster its growth and development without compromising its mission.
This is a fairly new entity structure that is gaining popularity among those who want to run, work at, and invest in socially responsible companies. Just like traditional corporations, B Corps can elect to have its earnings taxed at the corporate level or to pass through earnings directly to shareholders who will be taxed at the individual level.
Not every state offers the ability to create a B corporation so speak with an attorney if this structure interests you.
Choosing an Entity
No form of entity is right for all businesses—all have advantages and disadvantages. The form of entity that is appropriate for your business will depend upon which of these advantages and disadvantages has the greatest impact on your business. For example, if you plan to seek outside investors who may have differing tax and cash needs you will likely want a C corporation. On the other hand, if all owners of the business will participate actively in its operation and a good share of the business’s income will be used to fund working capital or capital acquisition needs, an S corporation will be attractive because of its employment tax advantages. If you do not intend to seek outside financing but want to have flexibility in capital structure, an LLC may best serve your needs. If you are of the socially conscious sort and have a business that provides a societal benefit but wants access to capital, then a B corporation should be considered.
There may be considerations relating to your choice of form for your new business that has not been addressed in this summary; however, hopefully, this information gets you thinking about the most advantageous form for your business to take.