Legal Corner is a recurring column in Silicon Bayou News, featuring a discussion of legal issues relevant to entrepreneurs and start-ups. Legal Corner is authored and edited by Michael Balascio and Michelle M. Rutherford, associates at the New Orleans-based law firm Barrasso Usdin Kupperman Freeman & Sarver, L.L.C. Michael and Michelle have significant experience advising small companies and start-ups with strategic and legal decisions. They are both licensed to practice law in Louisiana – with Michael also licensed in Massachusetts and New York, and Michelle in California.
After deciding to launch a new venture, one of the first questions fledgling entrepreneurs are faced with involves choosing a business form for their new entity. Generally speaking, there is no one correct choice of entity that is proper for all new ventures; instead, founders must consider the pros and cons of each type of entity, along with their own backgrounds, level of funding, and appetites for risk, when deciding how to organize their new venture. The entrepreneur’s choice of business entity can have wide-ranging ramifications, from subjecting the company to double taxation to rendering the founders and other owners of the company liable for the company’s debts. Below, we will discuss some of the pros and cons of some of the most popular types of business entities for start-ups.
The law governing business entities is different in each state. Instead of focusing on Louisiana or Delaware law, we discuss facets of business organization law that are pervasive and apply in most, if not all, jurisdictions. It’s also important to remember that your choice of business entity is not set in stone. While there may be some expense involved, it is usually a fairly simple and painless process for a company to change its corporate form.
Sole Proprietorships and Partnerships: If you go into business without filing any paperwork or making any decision as to how you wish to organize your company, the new venture will probably default to being a sole proprietorship (if only one owner is involved) or a partnership (if there is more than one owner). No paperwork or formalities are required to go into business as a sole proprietor or partnership; however, if you plan to hold yourself out to the public under any name other than your name or the names of the individuals involved in the partnership, it is generally advisable to register your trade name or “doing business as” name in order to protect your rights to use that name and also to ensure that no other person or entity is using that name.
The biggest downside to operating as a sole proprietorship or partnership is personal liability. You, or you and your partners, will be personally responsible for all debts of the partnership. In other words, creditors can come after you and your assets (like your house) if the business does not pay its bills or otherwise becomes insolvent. In a partnership, there are instances in which you can be liable for the business-related debts of your partner, even if you were not aware that he or she incurred those debts. The personal liability involved with sole proprietorships and partnerships should not be taken lightly, especially for those with significant personal assets.
C-Corporations: C-corporations are what you typically think of when you think of a corporation. Most of the large, national companies with which you do business are organized as c-corporations, and more often than not under the law of Delaware, which is friendly to officers and directors of corporations and also has a streamlined process for dealing with corporate disputes. To form a c-corporation, filings must be made with the secretary of state in the state in which you wish to organize. C-corporations must also comply with several corporate formalities, such as holding meetings and votes, and drafting documents such as the “articles of incorporation” and (usually) corporate by-laws. The expense involved with forming a c-corporation may be daunting to some entrepreneurs, especially those without much funding, but the benefits involved are substantial: the owners of a corporation (shareholders) that is properly formed and that complies with all requisite corporate formalities are typically not subject to personal liability for the corporation’s debts. In other words, if the venture goes belly-up, creditors typically cannot come after the assets of the shareholders. Furthermore, venture capital firms usually prefer to invest in companies organized as c-corporations. If you plan to offer different classes of stock or options to your employees as compensation, a c-corporation is usually the best option, as equity and option compensation to non-owners can be a daunting and complex matter – if possible at all – when the entity is organized as an s-corporation or an LLC.
The biggest downside to organizing as a c-corporation is double taxation. (Please check with your accountant or tax advisor for a more thorough report about the impact of your corporate form on your tax bill.) C-corporations are considered independent entities and are taxed on their income much like individuals are. Then, the owners of the corporation are again taxed on that same income when it is distributed to them. If the corporation is successful and the owners are in a high tax bracket, the losses from double taxation can be substantial.
S-Corporations: An s-corporation, or a corporation that makes an “s-election” by notifying the appropriate governmental body, functions much like a c-corporation but avoids the double-taxation problem. An s-corporation’s net income flows through the corporation and is generally only taxed when received by the owners of the corporation. Unfortunately, only certain types of corporations qualify for s-corporation treatment. A corporation can only make an s-election if it has under 100 shareholders, those shareholders are all individuals (i.e. not other business entities), and those shareholders are all American citizens. Typically, s-corporations can also only issue one class of stock. If your company will be seeking outside funding, organizing as an s-corporation can be problematic due to the limitations on what types of shareholders are permitted and the limit on classes of stock.
Limited Liability Companies: LLCs try to be the best of both worlds: they limit the liability of their owners, much like a corporation does, and also are not subject to double taxation. LLCs have become very much in vogue over the past twenty years and nearly every state has statutorily permitted the formation of LLCs. LLCs also typically operate more informally than corporations; for example, LLCs are not subject to the corporate formalities of holding regular board and shareholder meetings (although many LLCs choose to hold regular meetings that serve the same purpose). The owners of LLCs are referred to as “members” instead of shareholders, but the members’ interest in the LLC is typically subject to more restrictions – such as restrictions on transfer – than a shareholders’ interest in a corporation.
While LLCs have skyrocketed in popularity in recent years and also provide a number of protections to the owners of companies that choose to organize as such, they are not a perfect, be-all and end-all corporate form, and there are many instances in which organizing as an LLC might not make sense. For example, if you anticipate seeking outside funding for your company, it is typically better to organize as a c-corporation, which can offer different classes of stock to investors (while it is possible to organize as an LLC and offer the functional equivalent of different classes of stock, doing so can be complicated and can also require spending a great deal of money on legal, accounting, and other fees). In a similar vein, if you plan to offer equity interests or options to employees, doing so under a corporate organizational structure is usually less cumbersome and provides more (and better) options for tailoring compensation to each employees’ needs.
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There are other ways to organize your business, but the types discussed above are usually the most appropriate for start ups. At the end of the day, the type of business entity you choose depends upon a variety of factors, like your appetite for risk, your tax bracket, your personal assets, and what you see happening in the future with your venture. The decision must be made on a case-by-case basis, typically in consultation with your legal, tax, and financial advisors.