Choosing the appropriate business structure is one of the first hurdles for an entrepreneur.
First, knowing the benefits of adopting any formal business structure–limited liability is essential.
Limited liability separates an individual business owner or manager from the business itself.
Assuming certain corporate formalities are maintained (e.g., segregation of business assets from personal assets), the entity itself will be seen as separate and distinct from the owners and managers.
Limited liability protects a business owner’s assets from risk if the business fails to perform its obligations (e.g., breaches a contract) or damages someone or their property.
A business must be formed and registered with the State (e.g., filing a Certificate of Incorporation with the State of Delaware) to benefit from limited liability.
Suppose an entrepreneur fails to adopt a formal business structure.
In that case, the business will be either a sole proprietorship (e.g., one individual) or a general partnership (e.g., two or more individuals) and will not receive limited liability.
Other Benefits of Corporations and LLCs
The two most common business entities are corporations and LLCs, which not only enjoy limited liability but also provide a vehicle to:
1. Issue, track, and transfer ownership of the business (e.g., issue shares of stock to its founders, investors, and employees); and
2. To hold valuable property (e.g., intellectual property, contracts, real estate).
Notable Differences Between Corporations and LLCs
Although corporations and LLCs share many characteristics, there are significant differences when it comes to (1) governance, (2) tax treatment, and (3) funding options.
Generally, corporations have a more formal structure and distinctions between key stakeholders than LLCs.
For instance, in a corporation, the stockholders (i.e., owners of the corporation’s stock) have a limited role in the corporation’s governance—such as electing the Board of Directors and voting on significant corporate transactions (e.g., a sale of substantially all of the company’s assets).
On the other hand, the Board of Directors controls the direction and high-level management of the business, such as appointing and designating officers (e.g., CEO, CTO, COO).
In turn, the officers are responsible for the day-to-day operation of the business and can hire and fire employees.
Although individuals can, and often do, assume multiple roles (e.g., founders may be stockholders, directors, and officers), the scope of authority associated with these roles differs.
For example, if a stockholder wants to terminate or appoint a specific officer, that stockholder would need to convince the Board (or replace members of the Board with those friendly to the stockholder) to make such an appointment.
Conversely, LLCs are a bit less formal and generally comprise two key players: members (i.e., owners) and managers.
An LLC’s governance may be simplified so that the LLC is managed by its members (without a separate management group).
LLCs tend to have a smaller group of individuals that wear multiple hats, and the governance rights are dictated by contract (e.g., the operating agreement).
For tax purposes, a corporation may be categorized as a C-Corp or an S-Corp.
C-Corps pay an entity-level tax not paid by an S-Corp or LLC (unless the LLC elects to be taxed as a corporation).
The entity-level tax means the C-Corp must pay taxes on that profit at the corporate tax rate.
Conversely, S-Corps and LLCs are treated as disregarded or pass-through entities for tax purposes, meaning the entity itself does not pay federal income taxes.
Instead, the profits, losses, or deductions are allocated to the owners and must be included on the owner’s tax return regardless of whether such owner received an income distribution.
The default designation for a corporation is treated as a C-Corp.
Additionally, if a C-Corp declares a dividend (i.e., distributes a portion of its profits to its stockholders), those stockholders must pay taxes on that dividend.
The payment of income tax at the corporate level and then again by the stockholders on a dividend is known as the “double tax.”
The dreaded double-tax is a misnomer for many startups because:
1. The business may not be profitable early on (i.e., there is no entity-level tax or profits to distribute);
2. Salaries paid to the team will be deducted from any corporate-level income, and
3. The stockholders are likely the founding team and won’t have a substantial amount of income to benefit from an allocation of losses to offset the income (e.g., losses that could be allocated to an owner of an LLC or S-Corp).
Another critical factor in choosing between an LLC or a corporation is funding options.
For instance, businesses that can generate early positive cash flow may prefer to self-fund or obtain traditional bank financing (e.g., a line of credit).
Conversely, companies requiring substantial research and development or marketing before generating positive cash flow may be unable to self-fund or obtain traditional financing.
The latter is often the case for technology companies, which rely on venture capital to fuel business development and growth.
Many venture capital firms only invest in C-Corps.
Notably, venture capitalists make investments in portfolio companies through a fund, ordinarily structured as a pass-through entity, such as a limited partnership or LLC.
The fund comprises of the venture capitalist and its investors–known as limited partners.
Often, limited partners may be prohibited or restricted from investing in companies with pass-through tax treatment like LLCs.
For a pass-through entity, the profits and losses of the portfolio company would pass through to the fund, which would, in turn, pass through to the fund’s investors.
S-Corps provide another issue: they may only be owned by human U.S. residents and not corporate entities, which disqualifies the venture capital fund.
C-Corps also have a more formal and uniform governance structure with which venture capitalists are familiar.
C-Corps also provide a tax advantage in the form of the Qualified Small Business Stock (“QSBS”), which may allow investors to deduct millions in gains on a successful investment.
High-scale technology companies tend to incorporate as Delaware C-Corps, mainly due to their reliance on venture funding.
Conversely, companies with early positive cash flow and no expectation or intent to pursue venture capital funding tend to organize as LLCs or S-Corps to avoid the double-tax and receive the benefits of pass-through taxation (such as allocations of losses and deductions).
While I am a lawyer who enjoys operating outside the traditional lawyer and law firm “box,” I am not your lawyer. Nothing in this post should be construed as legal advice, nor does it create an attorney-client relationship. The material published above is intended for informational, educational, and entertainment purposes only. Please seek the advice of counsel, and do not apply any of the generalized material above to your individual facts or circumstances without speaking to an attorney.