Choosing the appropriate business structure is one of the first hurdles for an entrepreneur.
Limited Liability
First, it is important to know the benefits of adopting any formal business structure–limited liability.
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 being at risk if the business fails to perform its obligations (e.g., breaches a contract) or damages someone or their property.
To receive the benefit of limited liability, a business must be formed and registered with the State (e.g., filing a Certificate of Incorporation with the State of Delaware).
If an entrepreneur fails adopt a formal business structure, the business will be categorized as a sole proprietorship (e.g., one individual is engaged in the business) or a general partnership (e.g., two or more individuals are engaged in the business) 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.
Governance
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 large corporate transactions (e.g., a sale of substantially all of the company's assets).
The Board of Directors, on the other hand, control 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).
Tax Treatment
For tax purposes, a corporation may be categorized as either 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 that 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 a distribution of income.
The default designation for a corporation is treatment 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).
Funding
Another key 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 tend to rely on venture capital to fuel business development and growth.
Here is a blog on venture capital and a video.
Many venture capital firms only invest in C-Corps.
Notably, venture capitalists make investments in portfolio companies through a fund, which is ordinarily structured as a pass-through entity, such as a limited partnership or LLC.
The fund is comprised 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 in that 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 in 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.
Conclusion
High-scale technology companies tend to incorporate as Delaware C-Corps, largely due 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 LLC's or S-Corps to avoid the double-tax and receive the benefits of pass-through taxation (such as allocations of losses and deductions).
What how we think about choosing an entity.
Photo by Caleb Jones on Unsplash
Fine Print
This post should not be construed as legal advice for any particular facts or circumstances and is not meant to replace competent counsel. None of the opinions or positions provided are intended to be treated as legal advice or create an attorney-client relationship. This content may not reflect all current updates to applicable laws or interpretive guidance, and we disclaim any obligation to update this video.
