Selecting a business entity is one of the first things that an entrepreneur has to do when they decide to take their idea and forge ahead to build a business from it. There are several different entity types to choose from, and although we’ve highlighted many of those choices in this article, it is important to remember that in most cases entrepreneurs will be choosing between the limited liability company and the C corporation.
The type of entity founders choose will have significant consequences in terms of taxation, financing, and legal liability. Below, please find a summary of various entity forms and the most important aspects of each that you should consider when selecting an entity form for your business.
The C Corporation is the most common entity choice for high-growth businesses that intend to raise outside investment capital. These types of businesses commonly choose the C corporation as their business entity because (among other reasons) investors are familiar with C corporations and it is relatively easy to issue equity compensation to executives and other vital hires.
C corporations are also allowed to issue different series and classes of shares. This allows the board to create shares with different sets of rights and preferences, which is almost universally required in angel and venture capital financing transactions. On the other hand, C Corporations are subject to “double taxation”. This means that income taxes are paid both at the corporate level and at the individual level when dividends are paid out.
For example, if a C Corporation had $150 in profit, it would pay roughly $50 in taxes on those profits, leaving $100 available for distribution to shareholders. If you owned 25% of the C Corporation, you would receive $25 and pay tax on the $25 distribution. Examples of C corporations include Apple, Walmart and General Electric, and also most early stage, privately-held tech companies.
Limited Liability Company
The limited liability company (LLC) is relatively new form of business entity that is becoming increasingly common because it combines several desirable aspects of the C corporation, but also provides pass-through taxation structure like a partnership. Like a corporation, a limited liability company provides legal protection for founders’ personal assets in the case that a judgment is ever made against the LLC.
Early-stage startup founders will sometimes start their businesses in the LLC form because it is simple and quick to set up, but most will have to convert to a C Corporation when the time comes to raise capital through angel and venture investors. For founders of businesses who know they are not going to raise outside investment capital and who do not plan to compensate their employees with equity, the LLC is often the best choice because of its flexibility and pass-through taxation scheme.
The sole proprietorship is considered the simplest and most straight-forward business entity to create and operate (you can think of it as a semi-entity because it isn’t really separate from the entrepreneur). Forming a sole proprietorship does not require filing any initial business forms with the state government in which the business operates. However, owners of businesses organized as sole proprietorships must report the business’ profits and losses on their personal tax returns every year.
Also, owners of businesses that are structured as sole proprietorships are personally liable for all lawsuits filed against the sole proprietorship. Consequently, if the business is sued, the owner will be personally liable for any judgment entered into against the business. A sole proprietorship does not have perpetual existence – so if the sole proprietor dies, the business is dissolved.
A general partnership is another relatively simple business entity form – it is basically a group of sole proprietors working together. In a general partnership, the partners are usually not required to file documents with the secretary of state prior to formation, and they report the business’ profits and losses on their individual tax returns.
The partners do not enjoy limited liability, so the partners are individually liable for any judgments made against the business. A general partnership does not have perpetual existence. Therefore, if one of the partners dies or withdraws, the partnership is dissolved. For these reasons, we rarely see businesses formed as general partnerships.
A limited partnership is a legal entity that is similar to the general partnership. However, in a limited partnership the limited partners’ liability extends only to the amount they have invested. There is also a general partner who manages the partnership and is fully liable for its debts and business decisions.
We most commonly see the limited partnership used to structure investment funds. In that scenario, the general partner is an LLC (in most cases). Generally speaking, the general partner controls the business decisions and the limited partners have consent or voting rights over a limited set of issues. The death or withdrawal of a limited partner will not cause the limited partnership to dissolve. However, to continue the limited partnership, there must be at least one limited partner and one general partner at all times.
A commonly misunderstood entity, the S corporation is really just an IRS designation. Secretaries of States offices do not recognize an S corporation as a distinct entity type. Rather, an LLC or a corporation can elect to be taxed as a “Subchapter S” corporation. Basically, an S corporation is a legal entity in that is taxed as a partnership but is otherwise generally treated like a “mini” C corporation.
While a C corporation may have an unlimited number of shareholders, an S corporation is limited to 100 shareholders. S corporations are also limited in that they can only issue one class of stock and shareholders must be individual U.S. citizens or permanent residents (no entities or international individuals).
Some businesses elect to be treated as S corporations for as long as possible so that they can have most of the benefits of the C corporation structure without the burden of double taxation, and without the hassle of converting from an LLC to a C corporation at some point in the future. When an S Corporation needs to issue another class of stock or bring in investors that are venture capital or angel funds, these businesses convert to C corporations and are then subject to double taxation.
Certified Benefit Corporation
A certified benefit corporation is another new distinction that has emerged out of the socially-responsible business movement. Not to be confused with a benefit corporation, which is a distinct legal entity in some states, such as Delaware, a certified benefit corporation is a business that has gone through an assessment process by a non-profit group called “B Labs” in which the business is evaluated for its social contributions.
Earning the distinction as a certified benefit corporation may be valuable depending on the social views of your customer base, and does not affect your underlying entity structure. Contrary to what some think, for-profit entities can become certified benefit corporations. The certification does, however, mandate that businesses file annual disclosures explaining how they worked toward their socially-beneficial goals.
Finally, becoming a certified benefit corporation does not change the underlying tax responsibilities of the business. For example, if the business is structured a C corporation, it will still be subject to double taxation.
Fourscore takes pride in providing legal services to many certified benefit corporations including Vital Plan, Murphy’s Naturals, and HQ Raleigh. Examples of other benefit corporations include Patagonia and Ben and Jerry’s.
The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on. Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.