Unknown Unknowns: Entity Type
This is our first in a series of posts about Unknown Unknowns of Startup Finance and Accounting. Follow us @TripoliGroup for new posts and to suggest a future topic.
Once you have decided to start your venture an early decision is selecting an entity type. If you study each type in detail you will find advantages and disadvantages to each type. You may also decide there is no good answer for your company. The best thing to remember is that no decision is irreversible. There will be some costs, but if you ever decide a different type is right for your business you can change.
There are nuances to each, but for our purposes we will generally discuss: Sole Proprietorship, LLC, and Corporations both S-Corp and C Corp.
The simplest form of a business entity, Sole Proprietorship, is basically when you just start carrying on a trade or business. Legally speaking there is no separation between you the owner and the business. You can put a name on business cards, but it is really just you. One pro of being a sole proprietor is the savings monetarily and in time of filing with your Secretary of State. If you are selling goods and collecting sales tax you will still have to register with the local taxing authorities, but you can avoid a filing fee and articles of organization. Additionally, on the positive side is the lack of corporate reporting requirements. Most legal entities require some form of annual report to be filed with the state. If you are a sole proprietor, the only requirement will be tax filings. Obviously it is not all upside with the sole proprietorship and the biggest downside is unlimited liability. As the sole proprietor there is no limit to your losses related to the business. Most concerning is all your personal assets are fair game in any legal action. You can limit the impact with insurance; however, the risk still remains. The other disadvantage is not being able to take capital from outside investors. Granted you can get a traditional bank loan, but you do not have an entity to sale stock or units to investors. You will have to raise all your funds through personal savings or revenue.
Limited Liability Corporation:
Possibly the most popular entity type among small businesses is the Limited Liability Company (LLC). LLC’s are created by state law and act as a hybrid of the sole proprietorship and a corporation. The biggest advantage of the LLC is the L’s, limited liability. Unlike in a sole proprietorship the owners of a LLC are only liable up to the investment in the company. (There is an exception referred to as “piercing the corporate veil” which we will cover in a later post.) The second advantage over a sole proprietorship you may have noticed in the earlier sentence, ‘owners.’ LLC owners are called members and a LLC can have a single or many members. This leads to a disadvantage in that every time a new member is added the articles of organization must be updated. Also you do not sale shares of stock in a LLC, but units. This is not something most outside investors deal with and they will not invest in LLC’s. A final feature of the LLC can be both an advantage and a disadvantage depending on your situation. A LLC is considered a disregarded or pass-through entity for federal tax purposes. This means there is no taxation at the corporate level; instead taxes are paid by the owners on their personal returns. This avoids double taxation which we will discuss in the corporation section. However, if you have multiple members in your LLC you will have to prepare a Schedule K-1 for each owner. Depending on the number of members and the complexity of the ownership the tax savings may be totally wiped out on the K-1 preparation fees.
The entity most familiar to the average person is the Corporation. This is the most formal of the structures. Requirements start with filing with the Sec. of State in the jurisdiction where you decide to register (more on that decision later) and extend to authorizing the company’s shares of stock and holding annual board meetings. There are two forms of corporations, C Corp and S Corp. The greatest difference arises in the taxation and ownership restrictions. Essentially anyone can own or be a shareholder in a C Corp. S Corps on the other hand can only have 100 shareholders and they must all be at least an US resident alien. Additionally, S Corps can only have one class of stock. This means an S Corp cannot issue both preferred and common stock. If you are considering venture financing this is a deal breaker as venture capital typically buy preferred shares. If you are not concerned about the stock issue an advantage of an S Corp is they are a pass-through entity and avoid double taxation. Double taxation is when the company pays taxes on its earnings and the shareholders pay individual taxes either on salaries, dividends, or capital gains. Double taxation is considered a disadvantage of the C Corp. However, there is an advantage related to reinvesting the earnings. In all other entity types the owners pay taxes on the earnings of the entity whether they pay out the cash or not. This is avoided with a C Corp as the owners only pay tax on the money (or benefits) they receive from the company. If you have plans to reinvest the earnings to grow the business and not pay out anything to the owners this is a real advantage.