Choosing the Right Entity

One of the most important decisions to make when starting a business is what form the business entity will take. There are a number of options – sole proprietorship, partnership, limited liability corporation, corporation, S-corporation, etc. There are a number of different factors that go into the choice. These factors include legal considerations, tax considerations, nature of the business, growth plans, and capital requirements, among others. Some are easier to set up than others.

Sole Proprietorship

A sole proprietorship is easy to set up. As the name implies, there is just one owner. Depending on the state, you may need nothing more than a tax ID number, a business license, and a fictitious name filing. There is only one level of taxation – all the revenues, profits and losses flow through to the owner and show up on his or her tax return. The downside is that the owner doesn’t have any corporate form to shield him or her from liability.

Limited Liability Corporation

To shield themselves from liability, many entrepreneurs choose some form of corporation – either an LLC, a C-corporation, or an S-corporation. The LLC, or limited liability corporation, is a relatively new entity that is becoming increasingly popular. It combines the limited liability of a conventional corporation with the pass-through tax treatment associated with a partnership or sole proprietorship. You can have one or more members, and it can be managed either by the members, or by non-member managers. There is a great deal of flexibility in how you can organize and run an LLC, which will be reflected in an operating agreement. A single member LLC’s operating agreement can be fairly simple and straightforward, but multiple-member LLC’s typically have more complex operating agreements, to handle the allocation of profits and losses, capital accounts, etc.

Corporation

The corporation, or C-corporation, has been an option for many years. The corporate form shields the stockholders’ assets from corporate liabilities, under most circumstances, and you can have an extremely wide base of ownership. You also have the double-taxation issue, however. The corporation is a separate legal entity, and it pays tax on its profits. Any dividends to shareholders are then taxable income to the shareholder. Therefore, the same money is being taxed at two different levels. Of course, corporations are not required to make dividends, and many do not. In the high-tech industry, it has been fairly standard practice for corporations not to pay dividends to their shareholders.

S-corporation

The S corporation is merely a C-corporation that has made an election under the Internal Revenue Code to have pass-through tax treatment for its shareholders. There are limitations on being eligible to make such an election. Only domestic corporations qualify, and there can be only one class of stock and no more than 100 shareholders. Also, the shareholders have to be individuals or certain trusts and estates. Corporations, partnerships, and non-resident aliens cannot be shareholders of an S-corporation.

LLC or Corporation?

Anyone starting a business should consult with his or her legal and tax advisors before making a decision. There are a number of subjective considerations and factors which will weigh in favor or against any particular choice. For example, if one is planning to seek venture capital or to go public, forming a C-corporation rather than an LLC is the better choice. Venture capital firms don’t care for the unpredictable and unique management of LLCs, and prefer the familiar structure and management of a conventional corporation. In addition, VC’s cannot invest in an LLC. If you set yourself up as an LLC, and then seek VC funding, you will have to spend a lot of money changing from an LLC to a C corporation. Also, the LLC ownership structure simply isn’t a good fit for a publicly-traded company. It’s better to understand these nuances at the outset, and choose the right entity at the start. Otherwise, a great deal of expense will be required to convert or merge the LLC into a C-corporation. That’s money that could be better spent growing the business.

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