Choosing and Forming a Business Entity

This is not as mysterious a question as it sometimes seems to entrepreneurs.  On the other hand, your choice can have important implications, so it’s worth getting it right.

Do I Need a Business Entity?

You don’t need to form a business entity to do business.  If you want to do business in your personal capacity, you can.  For some businesses, that’s the best choice.  There are two main reasons why you might want to put your business in an entity.

First, it can protect your personal assets from the liabilities of the business.  This benefit shouldn’t be exaggerated.  If your business has no earnings, few assets and no track record, you will generally have to co-sign personally on significant contractual obligations (leases, bank loans, equipment leases etc.).  But a business entity can protect you from a variety of other potential liabilities.  For example, your business could end up with liability for injuring someone.  If you properly maintain the distinction between yourself and your business entity (follow this link for a discussion of how to do that), the entity can restrict many personal injury liabilities to the assets of the business.  Again, don’t exaggerate the protection.  You’re almost always going to be personally responsible for harm you personally do to other people.  That’s an especially important point if you have no employees.

Second, a business entity facilitates raising capital and sharing ownership and governance rights.  In theory, you could accomplish the same results through complicated contracts with your investors and colleagues.  But it’s a lot simpler to bundle all the business assets and liabilities into a “fictional person” and then parcel out the financial claims on that person and the governance rights over it.

So do you need to form an entity?  If you need to raise outside capital, you almost certainly do.  If there’s more than one owner of the business, it’s also almost certainly the best choice.  Otherwise, think about the risks you’re running, how well you can insure them, how much protection an entity would realistically give you, and how much forming and maintaining the entity will cost you.

Common Types of Business Entity:

C-Corporation:

The corporation is the most familiar form of business entity.  It is formed by filing a certificate (often called “articles of incorporation” or a “charter”) with the state.  The certificate sets out the corporation’s basic characteristics, including the types of shares and the shareholders’ rights.  A separate set of “bylaws” usually contains more detailed rules about how the corporation works (e.g. how board meetings or shareholder meetings are called).  Generally speaking, the corporation’s shareholders hold the equity interest and vote to elect a board of directors.  The board provides high level management and appoints officers who carry out operations.

A corporation can be formed in any state, regardless of where the shareholders, directors or officers are located.  State corporations laws differ in important ways.  The default is Delaware, which has the best developed and most flexible corporations laws, is easy to deal with on the technical side of maintaining the entity, and is regarded as neutral by sophisticated investors and managers.

If you form a corporation in Delaware, but you’re based in another state, you will generally have to qualify your corporation to do business in that state.  The qualification process, although not difficult, is roughly similar to the process of forming a corporation and generally subjects the corporation to that state’s corporate taxes.  California goes a step further and imposes parts of its corporations law on out-of-state corporations that meet certain criteria indicating that they are based in California.

A “c” corporation is not a different kind of entity, it’s a corporation that is treated, under federal and state income tax law, as a taxpayer, separate from its shareholders.  That is the default tax treatment of corporations.  The alternative, an “s” election, is discussed below.  The upshot of this is that the income of a “c” corporation is taxed twice if it is passed on to the shareholders through a dividend or if the shareholder realizes its value as a capital gain by selling stock.

LLC:

The limited liability company is the most flexible and popular form of business entity for closely-held businesses.  An LLC is formed by filing a certificate with the state, but most of the details are in a contract, generally called the operating agreement, between the members.  One of the advantages of an LLC is that it offers nearly unlimited flexibility to arrange financial interests and governance rights.  So generalizations about these matters are of limited relevance.  Generally, however, the LLC’s “members” hold the equity interest and the LLC is managed either directly by the members or by one or more “managers” elected by the members.

As with corporations, you can form an LLC in any state and then use it to conduct business in any other state.  Delaware is the default in sophisticated transactions, but small businesses generally form their LLCs in the state where they are located, to avoid the trouble and expense of qualifying to do business there.  See the discussion of corporations above for more details.

An LLC can, in theory, elect to be taxed as a “c” corporation.  This is rarely done.  Generally, LLCs are either disregarded or taxed on a pass-through basis.  An LLC is disregarded, for tax purposes, if it has only one member.  The member simply reports the LLC’s tax items (income, deductible expenses etc.) on the member’s tax return as if the LLC did not exist.  If an LLC has more than one member, it can be elect to pass through its tax items to its members, usually in proportion to their capital in the business.  The LLC itself does not pay income tax, but it files an “information return” with the IRS and state taxing authorities, reporting all of its tax items and the allocation among its members.

Other Entities:

An “s” corporation is a corporation that elects to pass through its tax items to its shareholders.  The pass-through is similar to an LLC, but the tax rules for “s” elections allow much less flexibility in how they are allocated.  The tax rules allow for only one class of shares.  They also restrict the maximum number of shareholders and the type of persons who can be shareholders (generally, only individuals and certain trusts).

Limited partnerships are similar to LLCs from a tax standpoint, but have more cumbersome governance rules.

General partnerships are also similar to LLCs from a tax standpoint and are easier to form (in fact, they can be formed accidentally), but their partners have unlimited liability.

Limited liability partnerships (LLPs) subject their partners to less liability than a general partnership, but more than an LLC.  They are generally used only by professional service firms that are not allowed to form as LLCs under the relevant state laws (mostly law and accounting firms).

There are a number of other entities, none of which are commonly used to form businesses.

What Kind of Entity Is Right for My Business?

Choosing the right kind of business entity turns largely on how your business is likely to generate profits and how you plan to finance it.

Venture Backed Companies Aiming for a Sale or IPO:  If your financing plan is to raise angel and venture investments and your plan to get a return on investment is to sell the company or to sell shares to the public in an IPO, you should form a Delaware “c” corporation.  There are technical reasons why this is true, but it’s not worth worrying about them since you can’t change them.

Businesses Aiming to Pass Servicing Revenues to the Principals:  If your business is financed by its principals and your goal is to produce revenue that you pass back to them, you should generally form an LLC, an “s” corporation or a limited partnership.  The reason is that these entities will subject the income to only one level of taxation.  All other things being equal, an LLC is preferable because it is more flexible and easier to form and maintain.  Generally, it will be more efficient to form your LLC in the state where the business is based.  You should consider Delaware if sophisticated outside investors are involved or if your plans for governance or the allocation of income and distribution of money are particularly complex.

The exception is situations in which self-employment tax is an issue.  Income passed through to the members of an LLC is generally treated as “self-employment” income and subjected to self-employment (social security and medicare) taxes.  That is not true of “s” corporations and limited partnerships.  This distinction is worth thinking about in two situations.  It can be very important if individuals (as opposed to other business entities) are passive investors in the business.  They will not appreciate paying extra taxes on the income on their investments.  It might also be worth thinking about self-employment tax if investors who work in the business can prove that the market salary for their services would be less than the employment tax cap (currently around $106,000) and they expect their share of the business income (not necessarily distributed cash) to be higher than their salaries.  If either of these situations apply to you or you’re not sure, you need expert advice from a tax lawyer or accountant.

Other:  If your situation doesn’t fit into the two scenarios above, you probably need to think more carefully about what kind of entity to form and how to structure the investors’ interests.  The basic parameters are tax treatment, flexibility and ease of maintenance.

Do I Need Advice?

It isn’t hard to form an entity.  You can probably get it done on your own or with the help of a reputable “incorporation service” company (CTC and CSC are the best known).  That said, there’s a lot of room to optimize and to make a hash of things.  Some mistakes can be corrected down the line.  Others can’t.  So it’s usually best to consult with an experienced lawyer and/or accountant to make sure you get it right and don’t miss anything important.