Company Formation - Entity Types
As an entrepreneur, you have a number of options when it comes to creating your own business. The three basic ones are: sole proprietorship (single-member LLC, single-member S corp, or single-member C corp), partnership (LLC/LLP/LP), or corporation (S-Corp/C-Corp). As you see, they break down further into subcategories. Below, I will try to give you an idea of how things interconnect, based on the readings I’ve done. This is mostly in regards to LLC and how they differ from other entities. I’ll try to skim on the obvious and focus on the less known:
- C-Corp: If you want to eventually go public, this is what you want to do. Every publicly traded company is a C-Corp; no exceptions. Moreover, almost all of the companies that receive venture capital (I am talking serious, multi-round venture capital, not just seed/angel investments), are C-Corps. That is because it has a rigid compliance structure that VCs and investors appreciate, as it requires mandatory disclosures, etc. Ths is a very formal company structures and it requires a number of procedures and documents (such as Articles of Incorporation, Current By-Laws, mandatory annual meetings, mandatory directors/officers/shareholders, mandatory minutes of all meetings and records of all shareholders, etc). As you can see, it’s not simple. However, on the bright side, C-Corp has no limitations on the class of stock issued (useful for multi-round financing, where various stock classes have various voting/management rights), and has no limitations on who holds the stock. As far as the law and the IRS are concerned, it is a separate legal entity, akin to creating a new person, and all the members are awarded limited liability from the corporation’s debts. Same “piercing of the corporate veil” idea applies to C-Corps, as to the LLCs though. Failure to maintain a company truly separate in the eyes of the court will cause them to go after your personal assets without a second thought.A lot of sources will say that an C-Corp is bad because it has double taxation, at the company level and at an individual level. That is only on dividends or on the assets distrubuted upon dissolution. Otherwise, C-Corps allow for “income-splitting”, which may actually prove to be better than straight-through taxation. That means, when a company is bringing in more profits than the members need to live on, they can split the money into salary and re-invested profits. Lets say your company makes $200K, and you have 50% ownership share of it. If it was a partnership, it would be taxed at a personal tax rate of 34% for the entire 100K. Which is 34K. However, if you have a corporation, you can pay yourself a salary of, say, 50K, which would get taxed at 34%, and have the other 50K remain in the business, reinvested. Then it would be taxed at the corporation level (15% for the first 50K, 24% for 50-75K, roughly 34% afterwards). You would save 34K - (34% * 50K) - (15% * 50K) = 10K in taxes over a partnership. However, if you have no profits yet, and are not planning to go public, setting up a corporation is both cumbersome, expensive, and time-consuming. However, most dot-coms are still corporations, simply because that’s what most VCs require.
- S-Corp: please note that there is no such legal entity as an S-Corp, it is simply a tax election which allows pass-through taxation, instead of regular corporate taxation. In order to create an S-Corp, members have to form a C-Corp, and go through ALL the requirements of forming one, and then file an IRS Form 2553, electing to tax their corporation as an S-Corp. This must be done within the first 2 months and 15 days of incorporation. The main advantage of an S-Corp is its ability to pass-through its profits into the members’ income tax returns. In other words, there is no independent taxation of the corporation as a separate entity (with its own tax return); all of the profits and losses of the company are passed straigth through onto the individials’ returns. This could be used to avoid double taxation and simply accounting procedures. On the other hand, an S-Corp is limited to 75 shareholders (who must be US citizens or legal residents) and can only issue one share of stock. As a result of these restrictions, an S-Corp is not favored by VCs, as it cannot go public.
- LLCs: Limited Liability Companys are not incorporated and cannot go public. They can issue multiple shares of stock, but mostly do not have a large number of members (less than 25 typically, including investors). They can have as little as one member and an indefinite lifespan. There are three types of LLCs: proprietorship, partnership and corporation. Let me go into a little more detail:
- Proprietorship: as a sole business owner, it is not prodent to operate as a sole proprietor, because you have full liability. Forming a single-member LLC is automatically taxed as a proprietorship under IRS rules. It can be claimed as a disregarded entity for tax purposes, which means, as far as IRS is concerned, it is not a separate entity. That allows the single member of an LLC to file regular 1040 tax form (with Schedule C: Profit or Loss from Business), while gaining limited liability protection. A single-member LLC can also elect to be taxed as a corporation. For that, it has to file IRS Form 8832: Entity Clasification Election and check off a “corporation” option. In addition, IRS Form 1120S: Tax Return for an S Corporation, must be filed with the regular 1040 tax form. Note: this is a single-member LLC choosing to be taxed as an S-Corp for tax purposes. This is NOT an actual, legal corporation-type entity. As far as laws and statues are concerned, it’s an LLC. It has simply elected to be taxed as a corporation from tax standpoint. This is not an S-Corporation formed by a convertion from an C-Corp (as discussed earlier), so there are no incorporation requirements to be met.
