Founders should understand that choosing a business entity isn’t one size fits all. That’s why founders should consult with legal and tax advisers to make sure that they choose the entity that works best for their circumstances.
“A big issue is that clients don’t always consult legal and tax advisers. They Google ‘start a company’ and go with one of the first links they find,” says Kevin T. Wills, shareholder at Babst Calland.
People also will call and say, ‘I want to start a company. Everyone says I should be a Delaware corporation,’ he says. That may be the case, but it’s important to talk it through first. A different structure may be better for your business.
Smart Business spoke with Wills about legal structures for startups.
What are some potential entity types?
When starting a business, most founders tend to consider three options.
- C corporation (C-corp). A traditional corporation that is run by a board of directors, owned by stockholders and subject to federal income taxation.
- Limited liability company (LLC). More of a contractual arrangement that is governed by an operating agreement and offers pass-through taxation.
- S corporation (S-corp). This is a corporation, but the company’s revenue passes directly through and is only taxed at the shareholder distribution level.
What about limited partnerships (LPs)?
LPs are still prevalent in certain industries, but LLCs have limited the utility of LPs. Generally, you can structure an LLC to operate like an LP, where a board of managers runs the company and members are passive investors who get distributions.
What are the advantages and disadvantages to each structure?
C-corps work well for startups that need to raise capital from professional investors or plan to give employees stock grants to supplement compensation. They can be more attractive for investors because many venture capital funds have tax-exempt members that cannot invest in entities with pass-through taxation.
One of the largest challenges with C-corps is the potential for double taxation, i.e., income taxes owed both at the corporate and shareholder distribution levels. However, in practice, when companies first start out, profits tend to be minor and often can be offset by expenses like salaries. Additionally, C-corps require more paperwork and cost more to set up.
For new companies, an LLC offers a lot of flexibility. There are fewer corporate formalities and it’s less expensive to form with less paperwork than a corporation.
An S-corp is a hybrid approach, with the structure of a corporation that avoids double taxation. S-corps are a good option if a limited number of people are starting a business. However, they only allow one class of stock to be issued and there are limitations on the number and nature of shareholders.
How hard is it to adjust the structure?
You can change corporate form as the business’s needs evolve, but there are costs associated with most conversions. Going from LLC to a corporation isn’t difficult, and S-corp status is a tax election, so you can convert either to a C-corp if the company enters a growth phase. If you start as a C-corp or S-corp and convert to an LLC, however, it can have adverse tax consequences.
It’s also not uncommon for third-party investors to require a particular structure before investing.
What other issues can pop up if the structure isn’t set up correctly?
You’ll want to work with your legal and tax advisers to curtail potential problems, which may include asking awkward questions. For example, stock and LLC membership interests are personal property, so you will want to make sure to account for what happens if one of the members gets divorced, passes away or wants to sell. Further, you will want to try to avoid requirements for unanimous consent because such requirements means one person can hold the business hostage.
Founders have numerous decisions they must make when starting their businesses, and it is important that they seek out professional advice to weigh the legal and tax considerations to ensure that they choose the best entity structure for their business.
Insights Legal Affairs is brought to you by Babst Calland