Business Startup Myth: I Can Form A Company With My Eyes Closed
Many entrepreneurs believe that entity formation is a “one size fits all” situation. However, the type of entity you choose to form in the beginning can really impact your business.
You may want to go after angel or venture capital. Perhaps you plan to bootstrap a small company and sell it off in a few years. Maybe you hope to open a lifestyle business, and manage it yourself until you sell it or pass it on to your children. You may intend to have one or more partners, or compensate valuable employees with equity.
Each business plan is unique, and “form” documentation simply cannot take into account all the nuances of your plan for the future.
Each type of entity has its pros and cons, and it is important that you pay attention to these details in the beginning. All have important tax consequences to consider, as well as varying degrees of complexity and maintenance. Most importantly, your ability to raise money is often affected by the type of entity you choose.
1. The C-Corp
Many automatically default to the C-Corporation as the oldest and most common structure of large businesses. If your company is going to do business around the country (or the world), raise substantial amounts of private capital, and create a traditional stock-option plan, then the C-Corp may be your best choice. The problem for small companies, however, is that equity owners of a C-Corp face double taxation- both on the company’s profits and then again on the individual shareholders when the company pays dividends. If the company sells all of its assets in an exit transaction, the double taxation can really bite. The C-Corp is also required to maintain more formal records than other types of entities.
2. The S-Corp
The S-Corporation relieves you of the C-Corp’s double taxation problem, and offers excellent tax benefits to its owners- but you cannot issue preferred stock, and generally only individuals (rather than other companies) have the ability to invest. There is also a limit on the number of individual investors an S-Corp can have. If you are actively searching for funding, these can be unattractive limitations. Many investors will require an investment of preferred stock so that they can get their return early- before you split the profits- but that is not an option if your company is an S-Corp. Also be aware that the S-Corp designation is merely an IRS election. There is no state level S-Corp filing available in most states. For more on this, please read Mike McGovern's blog post, "My Company is an S-Corporation, Not an LLC."
LLCs are very flexible, and they tend to be a safe choice for an early stage business. They offer essentially the same liability protection as the other two entities, while allowing the members to pass the income through to their personal federal income tax returns like an S-Corp, but without the S-Corp’s restrictive regulations on investors and securities. The documentation is simpler than that of a C-Corp or S-Corp and there are fewer required government filings. However, if you need to convert to a C-Corp to attract investors later down the road, the transition can be accomplished fairly easily.
While the above guidelines are helpful when setting up your company, there are many other questions that should be answered about your managing team, your investors, your partners, and your finances before deciding on an entity. We suggest you allow an attorney to help you make the appropriate decision, and we wish you the best of luck!
LEGAL DISCLAIMER: This article is not intended to be, nor may it be used as, legal advice or tax advice. This article shall be used solely for general, non-directed informational purposes. No attorney-client relationship has been formed by virtue of this article and Moster Wynne & Ressler, P.C. has in no way agreed or consented to provide you with legal representation by virtue of this article.