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When I launch my startup business, what type of legal entity should I form? October 12, 2010

Posted by Jim Price in Business, Entrepreneurship.
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In the U.S., you have several different options, and ultimately, I strongly advise business people to seek a lawyer’s advice.   [We had a savvy, broadly-experienced startup attorney visiting my MBA class recently, Jim Schriemer, a partner at Conlin, McKenney and Philbrick, schriemer@cmplaw.com  734-761-9000.]   But with that caveat, here’s an overview of the primary legal organization alternatives as I understand them: 

  1. C  Corporation Named after Subchapter C of the U.S. Internal Revenue Code, C corporations are the corporations with which the general public is most familiar:  most publicly-traded companies, for instance, are C corporations.  C corp.’s are taxable entities, subjecting the business’s profits to so-called double-taxation – that is, profits are first taxed at the corporation level, and subsequently any distribution of dividends is taxed a second time at the individual shareholder level.  The C corp. has become the standard organizational form, however, for businesses with many shareholders or multiple classes of shareholders; this is because the C corp. offers significant capital structure flexibility, and the body of law around corporations is very well-developed and well-understood.
  2. S  Corporation Named after Subchapter S of the U.S. Internal Revenue Code, S corporations are tax pass-through entities designed specifically to accommodate small businesses.  As “mini corporations,” S corp.’s are subject to many of the constraints binding C corp.’s.  For instance, they require a complete set of corporate bylaws, a full set of corporate officers, annual meetings of shareholders, annual reports and so on.
  3. Sole Proprietorship Legally, any individual can begin conducting business tomorrow as an individual as a sole proprietor – say, as an accountant or house painter.  As the name suggests, the sole proprietorship form of business is limited to a single individual, and the business’s financials are intermixed with the individual’s on her or his tax filings.  This legal form offers the business person no liability protection.  
  4. Limited Liability Company (LLC) –  A relatively new form of business legal entity created in the past twenty years, the limited liability company, or LLC, blends some of the more desirable traits of older legal organization forms but without the associated downsides.  For instance, as with an S corporation, the LLC is a tax pass-through entity; but unlike an S corp., the LLC frees the entrepreneurs from the constraints of a limited number of owners, a slate of officers, a board of directors, annual meetings, etc.  Conversely, the LLC form of legal organization offers entrepreneurs the flexibility of structure of a partnership, but with the liability shield of a corporation.
  5. PartnershipFor entities other than professional service organizations such as law firms and accounting firms – i.e., for most businesses – the partnership form of organization has been displaced by the limited liability company, since the LLC offers essentially all the advantages of the partnership form (flow-through taxation and flexibility of charter) plus the crucial added advantage of limited liability for the owners.   

As I noted above, most public companies are C corporations.  In addition, professional investors in early-stage private companies (venture capitalists) nearly always require that a privately-held startup company be in a C corp. form of organization before they will invest.  One reason is that they do not want losses to flow through to their books, since they would then have to, in turn, have those losses flow through pro rata to the taxes of their limited partner investors – something that most institutional investors such as pension funds, university endowments and insurance companies consider undesirable.

An additional reason that VCs prefer their portfolio companies be C corp.’s is that the form allows for a flexible capital structure, including multiple classes of stock.  VCs who are making a new venture capital investment in a startup company will almost always require that their stock be a new class of preferred stock that carries with it certain rights (such as liquidity preferences, approval rights over certain company actions, a certain number of board seats, etc.).

Even given the preference of venture capitalists for the C corporation form, entrepreneurs increasingly tend to launch their startup companies as LLCs (limited liability companies)

Why?  For several compelling reasons in my mind, as follows:

First of all, the vast majority of startups do not raise money from venture capital firms.  Even startups that eventually raise money from VCs almost always get off the ground at first with funding from founders, friends and family, or perhaps from a few angel investors.  Even if you think you might entertain raising capital from VCs later on, it’s very easy and inexpensive to convert an LLC to a C corp. at that juncture.  (Conversely, it’s very difficult and expensive to convert a company the other way, from corporation to LLC.)

Secondly, the LLC form of organization provides early-stage companies “the best of both worlds” as follows.  On the one hand, LLCs offer owners the limited liability associated with a corporation form – that is, owners are shielded from legal liability.  And on the other hand, LLCs offer owners significant advantages of the partnership form of organization, namely flow-through taxation. 

Here’s the beauty of flow-through taxation:  In the early stages of the business, when you experience losses, the owner/founders can personally benefit by passing those losses through to your personal income taxes.  Then, later on when the company is turning a profit, those profits are only taxed once; unlike in a C corporation – where profits are taxed at the corporate level, and then any dividends distributed to shareholders are taxed a second time as individual income – in an LLC, profits flow through to the individual owners and are only taxed once.

And thirdly, entrepreneurs appreciate the significantly greater flexibility of charter that the LLC offers over that of the Corporation form.  Whereas a corporation is required to name officers and board of directors, hold board meetings and shareholder meetings, pass board and shareholder resolutions, keep minute books, etc., the equivalent requirements imposed on an LLC are an order of magnitude simpler, dramatically less arcane and significantly more flexible.

Looking at the other side of the coin, the disadvantages associated with initially forming your startup business as a C corporation are clear:

  • Any losses remain on the company’s income statement, and offer no tax-loss benefit to the individual owner/shareholders.
  • Double taxation:  Any profits are taxed at the company level and a second time at the individual level if the company chooses to issue dividends.
  • If you initially form as a C corporation and later wish to convert to an LLC, such a conversion is quite complicated and expensive.

Are there circumstances under which it does make sense to legally form your startup as a C corporation from the very beginning?  Yes:

If you believe that you are going to raise venture capital immediately, you might as well launch your startup as a C corp. right away.  Again, VCs usually insist on the C corp. form for the companies in which they invest, due to the flexibility of capital structure.  In fact, if you suspect that one or more of your VCs may be from outside the state in which you are located, you may wish to consider organizing (filing) your C Corporation in the State of Delaware, since Delaware is the “legal gold standard” body of corporate law of which attorneys from all fifty states are familiar.

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