June 24, 2020 / by Andrew Fisher
The TL;DR (“too long, didn’t read”) version: Corporations and LLCs are the best choice for almost all new businesses, and Startomatic can get yours formed with no guesswork and no headaches.
Most founders have some idea of the variety of legal forms that they have to choose from when creating their new company. Who hasn’t heard of a corporation or a limited liability company (LLC)?
Only slightly less recognizable are entities like general partnerships (GPs), limited partnerships (LP’s) , sole proprietorships, and non-profit corporations.
And what about those more “exotic” choices - professional corporations (PCs), professional limited liability companies (PLLCs), and even limited liability limited partnerships (LLLPs) (holy cow)??
As if that’s not enough, where do “C-corporations” and “S-corporations” fit into all of this? Well… they don’t, really. But more on that later…
So any business founder has the right to be confused about choosing an entity type, and it’s no wonder so many feel the safe option is to seek out a business lawyer for solid advice. At Startomatic, we agree that lawyers can be extremely helpful in setting up many types of businesses with large or complex ownership bases, or those that are going to take in professional investment money (think venture capital investments in preferred stock) right after forming.
But for companies with just a few owners (somewhere south of 6-8) and a straightforward initial capital structure (all owners get the same type of equity), the best advice is KISS - Keep It Simple, Startups.
THE AWESOMENESS OF LIMITED LIABILITY
Your first question might be “why do I need an entity at all (and what the heck is an ‘entity’ anyway)?”
Entity is the catch-all term lawyers use to describe corporations, LLCs, and all of the other types of legal business forms described above.
And the best reason for running your business as an entity? It’s because you probably like your car, and your house, and your priceless collection of Pink Floyd on vinyl. If you run your business as an entity, all of those items of personal property are off limits if your new business fails and owes your creditors (landlord, material suppliers, contractors) money. Without an entity between you and your business’s creditors, those creditors can sue you personally and take your records AND your record player.
But if your company is a corporation, LLC or other entity with the legal protection of limited liability, those creditors can only go after the assets of the company (in most cases). Your classic Camaro is safe.
Using an entity to run your company has some other benefits as well - it can be easier to get business banking services, buy (or be bought by) another company, and enter into contacts. But the number one reason is the beauty and safety of limited liability.
CORPORATIONS - THE GRANDDADDY OF BUSINESS ENTITIES
Cast your mind way back, so far back that avocado toast wasn’t even a thing yet, and you’ll get to the 1790s. That’s when corporations took off in the U.S., and there’s a reason they’re still the dominant business form for most companies, particularly large ones: there’s no mystery about how corporations work.
Every corporation is owned by its shareholders (or stockholders; the terms are interchangeable), managed by one or more directors (the “Board of Directors” or sometimes just the “Board”), and operated by its officers (President, Secretary, etc.)
For this reason, professional investors (think: venture capitalists) tend to prefer investing in corporations. It’s also possible to grant employees stock options (the ability to buy stock in the corporation in the future) to encourage them to do their best work and to stick around. Stock options just don’t work well in LLCs, for a number of reasons that are WAY too boring to go into here.
On the flip side, the well-defined structure of a corporation makes them less flexible and means there are more corporate “housekeeping” matters to occupy your precious business time and attention. And as always, taxes come into play: a corporation’s earnings may be taxed twice (yikes!), once at the corporation level, and again when earnings are distributed to the shareholders. (But see the discussion on S-corporations, below.)
Here’s the skinny on corporations:
PROS of a Corporation:
- Limited liability
- Professional investors generally prefer corporations
- Easy to issue equity incentives (stock or stock options) to employees and others
CONS of a Corporation:
- Double taxation (without an S-election; see below)
- Limited flexibility in management
- Generally more complex to manage than an LLC
LLCS - THE CORPORATION’S YOUNGER, WILDER SIBLING
Corporations were almost 200 years old when the limited liability company came onto the business scene in the 1990’s. LLCs are basically state-approved contracts creating companies with the key benefit of limited liability (hence their creative naming) but much more flexibility in management and ownership structure than corporations.
LLCs are owned by their members and are managed either directly by those members or by managers. If compared to corporations, members are similar to shareholders, and managers are like a combination of directors and officers.
The LLC’s major difference from corporations is that the contract governing the LLC (usually called an Operating Agreement or an LLC Agreement) can say pretty much whatever the owners want it to say. So the financial terms of investment, tax allocations, and cash distributions, as well as who makes the management decisions in the company, can be anything the members (owners) agree to.
Perhaps most beneficially, LLCs are usually subject to pass-through taxation by the IRS, which means the company’s profits (and losses) are “passed through” directly to the owners - avoiding the corporation’s double taxation issue described above. This is the same way partnerships are taxed.
While the LLC’s flexibility is appealing to some, it has the drawbacks of being unattractive to many investors, and making it so awkward to issue incentive compensation (stock options) that it’s generally not even worth trying.
PROS of an LLC:
- Limited liability, just like a corporation
- Single level of taxation usually means tax savings
- Flexibility in financial and management means the owners can decide exactly how they want the business to run
- Fewer time-sucking administrative requirements than corporations
CONS of an LLC:
- Professional investors generally prefer corporations
- Nearly impossible to issue equity incentives to employees and others
TAXES ALWAYS COMPLICATE THINGS: THE S-ELECTION
The double taxation problem of corporations does have a solution - but it’s one that comes with significant limitations (of course, darn that IRS…)
An S-corporation isn’t actually a type of corporation at all; it’s just a description of a corporation that has elected with the IRS to be taxed like a partnership. By making this election, the corporation doesn’t pay taxes on its income; instead, the shareholders report and pay taxes on the company’s earnings (and can take the losses) directly on their own tax returns. This is “pass-through” taxation, just like the default taxation of an LLC.
So what are the limits on an S-corporation? They’re pretty significant. An S-corporation:
- Can have no more than 100 shareholders
- Can have only one class of stock (so no preferred stock, which is what outside investors usually want)
- Can only have shareholders who are individuals (so no companies can be shareholders, again meaning many investors are shut out)
- All shareholders must be U.S. citizens or lawful permanent residents
OK, but then what’s a C-corporation? Easy. It’s just a corporation that has not made an S-election.
Should your corporation make an S-election?
Probably yes, if BOTH of the following are true: (a) you meet all of the basic requirements described in the section above, and (b) you don’t intend to raise funds from outside investors in the near term. Keep in mind that you can always change from an S-corporation to a C-corporation in the future - you just have to make a filing with the IRS (and of course there are a few restrictions).
Should your LLC make an S-election?
Wait, so an LLC can make an s-election, and choose to be taxed like an S-corporation?? We hear you, this is confusing. For now, suffice it to say that there are some very specific circumstances in which an LLC might choose S-corporation taxation - and Startomatic supports that option - but generally speaking LLCs are better off without an S-election. We’ll blog more about this soon and link to it here when we do.
HOW TO CHOOSE: CORPORATION OR LLC
If you’re still unsure, take a look again at the lists of pros and cons above under the corporation and LLC sections. If you meet criteria for either entity and see benefits in each, in our experience the LLC offers more flexibility with less administrative headaches than a corporation, plus the automatic benefit of pass-through taxation, so it’s generally the right choice for new small businesses.
SOLE PROPRIETORSHIPS ARE EASY… AND RISKY
A quick note about sole proprietorships, which you may have heard of. A sole proprietorship is just running your business without an entity. It’s easy, fast, and usually free, but it’s missing the key benefit of limited liability (your classic Camaro isn’t safe any more), and for this reason it’s usually not a good choice.
That said, there are few businesses where the risk is so low that using a sole proprietorship may be a reasonable choice in order to save on filing fees and administrative work of setting up and operating an entity. For that reason, Startomatic will begin offering sole proprietorships in the near future - stay tuned.
SOME FINAL THOUGHTS
At Startomatic, we preach simplicity whenever possible, and that certainly goes for your choice of legal entity. A corporation (with or without an s-election) or an LLC will be the right choice for more than 90% of new companies. And if you decide in a few months or years that you want to make a change? No problem - it is usually possible to convert one type of company to another, or to change an s-election if you need to.
Remember, we’re not a law firm and not your lawyers, so if you think you may need something more exotic (remember those GPs, PLLCs, and LLLPS??), or if you have a very specific tax or ownership issue that isn’t covered in this blog post, you probably want to seek (and pay for) the advice of an experienced business attorney or CPA.
You can find more information, including FAQs and links to other blog posts, at www.startomatic.com.