Monetizing a business concept presents numerous considerations for ambitious entrepreneurs, but with careful forethought, founders can spend more time growing their business and less time worrying whether they made an incorrect decision in their startup formation. The primary goal of every founder should be to select the form of legal entity that aligns with their startup’s business model and serves as an attractive vehicle for investment. The form of entity will not only influence the startup’s business decisions, but it will also dictate the ownership structure, as well as the obligations and duties of those involved in the business.
Founders are cautioned to avoid the “one-size-fits-all approach” because two sets of circumstances are never alike. In the United States, founders are permitted to conduct their business through a corporation (including an S corporation), partnership, limited liability company (LLC), or sole proprietorship. A corporation is a separate legal entity apart from its owners (referred to as shareholders or stockholders). A partnership is a hybrid entity, where it is considered a separate legal entity in some situations and disregarded in others, such as certain legal liabilities and taxes.
An LLC generally incorporates the best features of the corporation and the partnership by providing limited liability protection to its owners (referred to as members) and the flow-through tax attributes of a partnership. Unlike the others, a sole proprietorship generally has no legal distinction from its owner, which may be problematic for a startup because the sole proprietor bears unlimited personal liability for the business’ operations. While there is no perfect answer for every situation, the discussion below provides a series of questions every founder should consider when selecting among available business structures.
Who owns the business?
Startups typically can choose any legal form for their business, though specialized rules and requirements may limit the choice of entity for some. Sole proprietorships are only available to businesses with a single owner. Additionally, federal income tax law places restrictions on the type and number of shareholders for S corporations.
For startups anticipating raising institutionalized equity or someday going public, structuring the entity as a corporation is desirable because the equity (referred to as stock or shares) is readily and easily exchangeable. Prospective investors, such as venture capital funds, are likely to prefer a corporate structure for which to invest, given that the fund may include investors, such as pension funds, charitable organizations, and trusts that are subject to special tax rules.
However, some investors may favor the partnership or LLC structures because the governing documents for such entities (referred to as a partnership agreement or operating agreement) possess greater flexibility to tailor to the owner’s expectations and requirements for investors (such as voting and economic rights, etc.) and to permit distributions of cash (or property) in a more tax-efficient manner.
How will the entity be taxed?
For corporations (other than S corporations, which possess the flow-through tax attributes of a partnership), the entity will be subject to corporate income taxes, at the federal, and in many cases, at the state level. Currently, the federal corporate income tax rate is set at a flat 21%, whereas state income tax rates vary significantly. (For 2021, the lowest corporate income tax rate is in North Carolina, set at 2.5%; the highest is in New Jersey, at a current maximum rate of 11.5%.) Additionally, any distributions from a corporation to its shareholders will be taxable dividend income to the recipient, taxed according to the shareholder’s individual income tax bracket. Rates at the federal and state levels vary according to the recipient’s annual gross income.
For partnerships, S corporations, LLCs, and sole proprietorships, their earnings are taxed directly to owners who are subject to tax on the entity’s earnings. By default, LLCs are taxed as a flow-through entity—however, it may elect to be taxed as a corporation. However, some states may impose an entity-level tax, notwithstanding that the startup is a flow-through entity for federal income tax purposes. (For example, Tennessee imposes a Franchise and Excise Tax on certain businesses structured as LLCs, unless the entity meets the requirements for an exemption.). Founders should consult their legal and accounting advisors to determine any additional state tax obligations for which it may be responsible.
How will the business raise capital?
Other than sole proprietorships, most structures can raise investment capital without various legal or tax restrictions, including through the use of equity (common or preferred), debt (convertible or non-convertible), warrants, options, and other derivatives. For startups raising capital (at least initially) through family, friends, strategic investors, and other high net worth individuals or family offices, an LLC provides the investor the opportunity to dictate the terms and conditions that the corporate form cannot. For other investors simply seeking an investment to provide a return on their investment, a corporation is more desirable, as the primary communication between the entity and the investor will be annual tax information statements and shareholders’ meeting notifications.
In addition to the foregoing, founders should consider the legal and tax incentives available to the above-mentioned structures. For certain entities classified as qualified small business corporations, shareholders can shield 100% of any capital gain upon their exit from the business, as well as a tax-free rollover from one investment to another. This highly preferential exclusion only applies to certain corporations, including most startups formed as corporations. Similarly, under the current federal income tax laws, owners of pass-through entities – such as partnerships, LLCs, and S corporations – can take up to a 20% deduction on their share of the entity’s net business income subject to certain requirements and restrictions.
Selecting the appropriate legal form is an important decision for any startup. In all situations, founders should consult with their legal advisors regarding the most appropriate vehicle for their business.