The Right Choice: What Kind of Entity to Create
By Douglas J. (DJ) Drennan, Spaulding McCullough & Tansil LLP
Making the right choice about the kind of legal entity you create for your company has an impact on taxes and liability.
One of the most important choices that an entrepreneur must make when starting a business is deciding what type of legal entity is best for the venture. There are a variety of business forms, including sole proprietorships, general partnerships, limited partnerships, limited liability partnerships, limited liability companies (LLCs), corporations, and professional corporations. Because of the liability protection and tax planning opportunities described below, most high-technology startups use an LLC or corporation. Because of the requirements of many venture capitalists, most startups planning to seek venture capital financing use a corporation.
In determining which entity is appropriate for your business, there are two major considerations: liability and tax. For example, in a general partnership, the owners (called partners) are jointly and severally liable for the business’ debts and other obligations, and all profits and losses flow through the entity and are taxed at the individual partner level in proportion to their ownership interest. Like the general partnership, a limited partnership is a disregarded entity for tax purposes, but only the general partners are personally liable for the business’s liabilities, whereas the limited partners are liable only up to the amount of their investment.
In contrast, all the owners of a corporation (called shareholders) are liable only up to the amount of their investment, but the profits of the business are potentially subject to double taxation—once at the corporate level and again at the shareholder level if the corporation declares dividends or makes certain other distributions to the shareholders. To avoid double taxation, the shareholders may elect, provided certain requirements are met, to have the corporation treated as an S corporation, in which case the shareholders still enjoy the limited liability of a corporation but all profits and losses flow through to the individual shareholders. Similarly, LLCs also provide business owners limited liability and flow-through tax treatment. The LLC offers its owners (called members) the same level of limited liability as a corporation (limited to amount of investment) and the same tax treatment as a partnership (flow-through). As a result, both S corporations and LLCs are attractive options in many situations, although there are a number of tax and non-tax factors to consider in determining which, if either, is appropriate.
In addition, once you have decided what type of entity is appropriate, you then need to decide what jurisdiction is best. Generally, the decision is between the state where you are located or the state of Delaware. Because of the requirements of many venture capitalists and other reasons, most startups planning to seek venture capital financing incorporate in Delaware.
So what is the right choice for your business? Here are a few things you should consider:
- Will you operate the business alone or with others?
- Do you expect to raise working capital?
- Do you expect to seek venture capital investors?
- Do you expect to hire employees? Do you want to grant stock options to your employees?
- What risks and liabilities are associated with your business?
- Are you required to be licensed by the state?
- Is the business likely to attract litigation?
- How fast do you expect your business to grow?
- What is your exit strategy?
It is important to take the time now to carefully consider the pros and cons of each choice of entity and jurisdiction and how they will affect your venture. The right choice now will help you avoid having to make bad choices later.