Organizing the Company – Choice of Entity

Bench to Market (article)In the first installments of the Bench to Market series, we discussed how to secure and protect intellectual property rights to technology that will be central to the venture. Once the entrepreneur is confident these rights are secure, it is time to form the legal entity that will carry on the business of developing the new technology. It is generally a good idea to create a company early in the process to avoid the necessity of assigning contracts and taking other legal steps that might be required if legal arrangements are made initially in the names of individual entrepreneurs.

It is also important to conduct all business related to the new technology through a company structure so that there is no confusion about who is responsible for the company’s obligations. If a corporation, partnership, or LLC is formed, capitalized, and operated properly, the new legal entity constitutes a separate and distinct “person” for all purposes under the law, and the company, as opposed to the entrepreneur who forms it, will be liable for the debts and obligations of the business. While this is not true in all situations (for example where the owner has personally guaranteed a debt of the company or where the owners have failed to provide appropriate capitalization), the “limited liability” that a separate legal entity provides can and often does prove to be crucial.

Basically, four types of legal entity are available, all formed under the law of the state in which the entity is formed: the regular corporation (or “Subchapter C Corporation”), the Subchapter S Corporation, the partnership, and the limited liability company. The entrepreneur must take into account several important considerations, including very significant differences in how the business will be taxed, in choosing the appropriate form. No single entity type is the right choice for all new businesses and owners should consult with their advisors regarding the best choice. Below is a brief summary of the legal entities most typically used for a start-up company and certain advantages and disadvantages of each.

Subchapter C Corporations

Description of a Subchapter C Corporation

For many years, the Subchapter C Corporation (a “C Corporation”) was the preferred choice of legal entity for most businesses. Because of its long tradition and the many years of court cases that have clarified the legal relationships that flow from the C Corporation, it remains a popular choice for many entrepreneurs. Most larger companies, and virtually all “public companies,” such as those traded on a stock exchange, are C Corporations. The principal disadvantage is the burden of “double taxation” that falls on a C Corporation and its shareholders.

Advantages of C Corporations

  • C Corporations provide solid limited liability protection, subject to few limitations regarding management of the business.
  • C Corporations afford entrepreneurs significant flexibility in designing the capitalization of the new business. For example, shareholders may hold any of several classes or series of preferred stock or common stock, and there is no limitation on the number of shareholders. Start-up companies that intend to engage in offering investment shares broadly to the public or obtain venture capital investments typically are structured as C Corporations. In certain circumstances, however, an LLC or an S Corporation may be a better choice so that early tax losses can flow through to the benefit of investors. Both LLCs and S Corporations may be converted into C Corporations, although there may be a tax cost related to doing so.
  • Shareholders of C Corporations are not taxed on the earnings of the corporation, but only on dividends and other distributions of cash or assets made by the corporation. Because the highest corporate tax rate is presently lower than the highest individual rate, and because most corporations are taxed at graduated rates, less total taxes may be paid on earnings that are retained by a C Corporation. This would be beneficial if the corporation will make few, if any, dividends or distributions during the growth stage of its business.

Disadvantages of C Corporations

  • Unlike LLCs, S Corporations, and partnerships, C Corporations are separate taxpayers: they pay taxes on their own earnings and shareholders pay a second time, at ordinary rates on dividends and typically at capital gains rates on the sale of C Corporation stock. This “double taxation” is the principal disadvantage of the C Corporation.
  • Unlike an S Corporation shareholder, LLC member, or partner, a C Corporation shareholder receives no direct tax benefit from tax losses incurred by the C Corporation.
  • Unlike an LLC, a C Corporation that dividends or distributes to its shareholders assets that have appreciated in value would be taxed on the amount of appreciation.

Subchapter S Corporations

Description of a Subchapter S Corporation

An S Corporation is a corporation, formed under state law like a C Corporation, that has elected to be taxed under Subchapter S of the Internal Revenue Code. The “S election” allows the corporation to avoid double taxation, but at a price. An S Corporation must satisfy each of the following conditions: (1) it generally cannot be a foreign corporation; (2) it must have no more than 100 shareholders; (3) each shareholder must be an individual, estate, or a specified type of trust; (4) no shareholder may be a nonresident alien; and (5) the corporation may have only one class of stock. The principal advantage of S Corporation status is the avoidance of double taxation: if structured properly the S Corporation is not taxed as a separate person. The principal disadvantage is the lack of flexibility in structuring the company’s capitalization. For example, most venture capital or private equity investors would not qualify as S Corporation shareholders.

Advantages of the S Corporation Form

  • Like LLCs and partnerships, S Corporations avoid double taxation.
  • FICA taxes may be minimized through payment of a reasonable salary to shareholder-employees, with the remainder of the company’s profits being distributed as dividends that are not subject to FICA or self-employment taxes.
  • S Corporations can be converted to C Corporations if and when necessary, although there may be some tax cost to doing so.

Disadvantages of the S Corporation Form

  • S Corporation capital structures are not as flexible as those of C Corporations. S Corporations may have only one class of stock. Venture capital funds and other institutional investors may not hold stock in an S Corporation because only individuals, estates, and certain trusts may be shareholders in such entities.
  • A dividend or distribution by an S Corporation of assets that have appreciated in value is a taxable event for the corporation’s shareholders; a similar distribution by an LLC or partnership is generally not taxable.
  • There is no step-up in the tax basis of an S Corporation’s assets upon a sale of stock or the death of a shareholder, but such a step-up can be achieved by an LLC that makes the appropriate election under the Internal Revenue Code.
  • In contrast to the tax treatment of LLC members, S Corporation shareholders do not include third-party debt in the tax basis of their shares, which limits the shareholder’s tax benefit from such losses.
  • An employee who receives S Corporation stock is taxed immediately upon the receipt or the vesting of the shares.

Limited Liability Companies

Description of a Limited Liability Company

Since the 1990s, limited liability companies, or “LLCs,” have become the most prevalent form of legal entity for new businesses. An LLC has characteristics of both a corporation and a partnership. Like a corporation, an LLC affords its owners (who are called “members”) solid limited-liability protection but allows them to design a flexible financial and management structure. Unlike a C Corporation, an LLC is not taxed as a separate person and thus avoids double taxation. In addition, like partners of a partnership, LLC members are able to claim the benefits of tax losses incurred by the company.

Advantages of the LLC Form

  • LLCs are very flexible, allowing customized management and economic structures. Unlike an S Corporation, there is no limitation on the type of entity that can be an owner or investor in an LLC.
  • Because the LLC is a “pass-through entity” for tax purposes, LLC owners endure only one level of taxation on profits and generally may claim LLC losses immediately on their individual tax returns.
  • Unlike limited partners of a partnership, LLC members enjoy limited liability even if they participate directly in management of the business.
  • An LLC can easily merge or consolidate with a corporation, a limited partnership or another LLC. Furthermore, contribution of equity or assets to an LLC can be accomplished more easily for tax purposes than with a corporation.
  • Upon a sale of assets by an LLC, the purchaser may receive a “stepped-up basis” in the assets purchased, allowing the purchaser to enjoy greater depreciation deductions, while there is no tax at the LLC level on such gain.
  • Unlike a C Corporation (and sometimes an S Corporation, where taxation of appreciated assets can be complicated), LLC owners are not subject to double taxation upon an LLC’s dissolution and liquidation.

Disadvantages of the LLC Form

  • LLC owners who are also employees generally must pay self-employment taxes and make estimated tax payments.
  • Many venture capital funds and institutional investors prefer to invest in corporations, because of the longer tradition and more carefully worked out legal ramifications of ownership, in addition to the hope that the company may eventually sell shares broadly to the public or be acquired by another corporation in a tax-free transaction.

Partnerships

Partnerships have been used for many years in all types of business relationships. A partnership can take the form of either a general partnership, which has only “general partners,” or a limited partnership, which has both general partners and “limited partners.” Limited partnerships provide limited liability protection to limited partners, subject to certain rules and restrictions, but every partnership must have at least one general partner who would be liable for all debts and liabilities of the partnership. Partnerships offer great flexibility in the design of a business’s capital structure and also afford significant tax advantages to the partners. Because LLCs are able to offer similar flexibility and tax benefits without the necessity of one or more general partners, LLCs have largely superseded partnerships as a legal entity for many technology start-up businesses.