One of the most pressing issues that early-stage entrepreneurs face is the question of what type of legal entity to form for their business. The answer to that question depends a great deal on the specific goals and needs of the entrepreneur.
There are a wide range of options available, including sole proprietorships, general partnerships, limited liability companies and corporations. In most cases, attorneys will recommend forming either a limited liability company (“LLC”), a C Corporation (“C Corp”) or an S Corporation (“S Corp”). Below is a brief discussion of some of the important features of these three types of entities.
Basic Ownership Structure
Ownership interests in C Corps and S Corps are divided into “shares.” The owners of shares in a corporation are referred to as “shareholders.” Ownership interests in LLCs are divided into “units,” and the owners of interests in LLCs are commonly referred to as “members.” Unlike LLCs and S Corps, C Corps are permitted to divide their ownership interests into preferred shares and common shares. This type of structure gives holders of preferred shares preferential distribution of dividends and special voting rights. LLC units and S Corp shares are generally all treated equally for purposes of voting and distributions. S Corp ownership is legally capped at 100 shareholders, but there is no firm limit to the number of people who can hold shares in C Corps or LLCs.
Shareholders in corporations and members of LLCs all generally enjoy limited liability protection. “Limited liability” means that the company’s creditors cannot reach beyond the assets of the company to gain access to the assets of the company’s members or shareholders.
Management requirements for corporations are much more strict than the requirements for LLCs. Corporations are generally required to elect a board of directors whose activities are dictated by the company’s bylaws. Among other requirements, corporations are generally required to hold formal meetings periodically, and maintain detailed records regarding meetings and related matters. LLC management is much more flexible and there is no requirement that a board be elected or meeting minutes be kept. Even though there is no requirement for meeting minutes, it is recommended that members keep minutes.
LLCs and S Corps both enjoy what’s known as “pass-through taxation.” This structure allows business owners to pay taxes on business profits on their personal tax returns. C Corps, on the other hand, are taxed directly on all business profits. Selecting a C Corp therefore creates the risk of double taxation for shareholders, as taxes may be paid by the corporation on its income and again by the individual shareholders on dividends and profits. On the other hand, in the event of an audit of the company, C Corp shareholders’ tax liability is unlikely to change, whereas individuals who take advantage of pass-through taxation might have their personal tax liability affected by an audit.
In many states, it is generally simpler and less costly to set up and pay taxes for an LLC than a corporation. Under most circumstances, corporations will result in higher fees paid to accountants and attorneys at the outset and at tax time. However, this is not true in all cases. For example New York requires members of new LLCs to publish notice of formation, which can cost several hundred dollars or more depending on the location of the LLC. If formation costs are a major concern, founders should check the state filing requirements and discuss with an attorney the different costs associated with forming each type of entity.
Venture capitalists generally prefer to invest in C Corps. The structure of this type of entity provides shareholders with a great deal of flexibility to sell shares of of the business when the time comes. Also, it is an important benefit for potential investors to have the option to designate some shares as preferred shares.
Only U.S. citizens and lawful permanent residents are legally permitted to own shares in S Corps. There are generally no restrictions on foreign ownerships of other types of entities in the U.S., though there may be some immigration consequences for business owners or shareholders who are present in the U.S. and involved in revenue-generating enterprises.
If a company’s first priority is flexibility for owners and managers, an LLC might be the way to go. Founders who are more focused on attracting and securing investments might prefer to form a C Corp. If the priority is favorable tax treatment for dividends, an S Corp might be optimal. Entrepreneurs on the verge of forming a new business will likely want to consult with an attorney to find out which type of company best fits their needs, as each approach has its own set of pros and cons.