When starting your business, one of the first things you need to do is choose the appropriate business form. Establishing a separate entity for your business creates a legal distinction between you, the founder as an individual, and your business.
It allows the business itself to issue shares to co-founders, own intellectual property rights, hire employees, enter into contracts, and perhaps most importantly shield the owner from personal liability for the debts of the business.
Based on the specific requirements of your business, a lawyer can help you make a decision on which entity is best suited to your needs. Below we breakdown some of the most common entity formations and discuss which form may be right for your business.
The Inside Scoop on Possible Legal Entities
A sole proprietorship isn’t a separate legal entity at all. There is no legal separation between you and your business, and it is the simplest structure to form. With a sole proprietorship, you are personally liable for all activities of the business: all expenses and debts of the business are yours, and so are the tax obligations.
This liability also extends to the actions of your employees. There is no scope for outside investors so this form of business makes more sense if you plan to run it yourself indefinitely.
When two or more people run a business together, they can create a general partnership by entering into a partnership agreement. Additionally, a general partnership is formed by default when two or more partners act in concert. The partnership functions and can take actions as a separate entity, distinct from the individual partners.
Even though forming a general partnership is fairly simple and inexpensive, the liability of each partner is unlimited, both with respect to his own acts as well as acts of other partners. This liability extends to losses of the partnership and suits filed against any partner acting for the partnership. Furthermore, the liability is for the entire amount of the partnership obligation, not just the partner’s contribution. Because of the unlimited nature of this liability, the general partnership is a very risky business form.
A Limited Partnership is a variation on the general partnership. The entity consists of a combination of general partners, who manage the business and take on liability, and limited partners, who usually contribute capital, but only have limited liability.
This is a good option for investors who want to maintain a passive role in the organization (as limited partners) and for founders who want to keep control of major decisions (as general partners), albeit taking on all liability. Both general partnerships and limited partnerships have a flow-through tax-structure, meaning that all partners are taxed individually and not at the entity-level.
A Limited Liability Corporation, often abbreviated as an LLC, is a popular business form for certain companies. Unlike any of the entities above, the LLC offers its members limited liability. Essentially, it combines the ease of formation of a general partnership with the limited liability offered by a corporation.
While an LLC provides tax advantages for stakeholders, it creates limitations on who can invest in the company, in particular a restriction on investment from venture capitalists. Forming an LLC requires the filing of Articles of Incorporation and typically an operating agreement, which sets out profit sharing, decision-making, and allocation of interest amongst members.
The C Corporation is a separate legal entity, which is liable for its own debts and obligations. It also has perpetual existence, so the corporation will continue to exist even if all its owners die. Investors can invest by acquiring shares of the corporation, of which it can issue various forms with various preferences.
This is why most venture capital funds prefer the C Corp, since it can issue preference shares and shields them from personal liability. In this form of business entity, ownership and management are separate and governance is very structured. The stockholders elect directors who make decisions for the corporation, making this another suitable choice for the passive investor.
The C Corp, however, functions as a separate taxable entity, meaning that its earnings are taxed twice: once at the entity-level and once at the stockholder-level on dividends.
The S Corporation has similar features to the C Corporation, but differs primarily with respect to tax structure. The S Corporation has a flow-through tax structure that taxes income only once: in the hands of the shareholders.
There are however, some limitations when opting for an S Corp structure: the number of shareholders is limited to a 100 and to individuals, certain tax-exempt organizations and trusts. This makes it difficult for a fund to invest in the business, since it does not usually fall under those limited structures. Further, the S Corp can issue only one class of stock, meaning that it cannot issue cheaper stock to employees or preference stock to investors.
If your enterprise is a purely social enterprise, or a combination of a non-profit and profit making business, there are newer entities to choose from.
The Public Benefit Corp or the ‘B Corp’ has a social, environmental or charitable purpose as its corporate purpose, therefore requiring consideration of all stakeholders and not just shareholders.
The Low-Profit Limited Liability Company or L3C is an LLC dedicated primarily to a charitable purpose, and only secondarily to profit generation. You can read more about these structures in our post here.
Which Entity Is Right for You?
Understanding the various forms of business entity helps you choose the appropriate one for your business. Consulting a lawyer is the easiest way to ensure that you choose the right entity, which could mean reducing exposure to liability, saving on taxes and ensuring your business can be financed and conducted properly.
Although sole proprietorships and partnership are prevalent business forms among small family run businesses, most lawyers will tell you that the lack of limited liability makes them a risky entity choice for most, if not all, businesses. An LLC, as compared to sole proprietorship or partnership, is almost always the better choice for businesses wary of expensive liability, such as slip-and-fall at a commercial storefront. If structured correctly, then an LLC will be taxed the same as a partnership.
Most large and emerging growth companies operate as C Corporations. Despite the tax advantages of other entities, C Corporations offer these businesses limited liability for stockholders, the most defined and well-understood governance laws, and the easiest way to transfer corporate stock. C Corporations are also eligible to issue Incentive Stock Options and are eligible for Qualified Small Business Stock. Most importantly for companies seeking outside investment there are not the limitations on who can invest in a C Corp, as with S Corps and LLCs. However, for businesses who do not plan on growing to public companies and who want greater flexibility when allocating profits, flow through taxation creates a strong incentive to form an S Corp or LLC.
By choosing the right business form you can reduce exposure to liabilities, benefit from the maximum tax advantages and ease the process of financing and running your company. A Priori attorney can help you decide on the best way to structure your entity based on the specific nature of your business and your future plans.