Critical Issues When Deciding on a Corporate Entity
The primary considerations when choosing a business entity is (1) the degree to which the entrepreneurs’ personal assets are protected from the business’ liabilities, (2) the availability of favorable tax strategies (like maximizing the tax benefits of start-up losses, avoiding multiple layers of taxation, and converting ordinary income to long term capital gains), (3) the company’s attractiveness to potential investors and lenders, (4) the availability of attractive equity incentives for employees and consultants, and (5) the costs of starting-up and operating the enterprise. All of these factors is important when choosing a form of business enterprise.
The three most popular forms of business enterprises are (1) corporations, (2) limited liability companies, and (2) partnerships. A corporation is created as either C-Corp. or S-Corp. The different structures affect distributions and taxation on the company and its shareholders. A partnership is created as either a general partnership or limited partnership. The different structures affect the personal liability of the partners. A limited liability company is created as either a member managed enterprise (for small companies) or a manager-managed enterprise (for larger more complex companies).
Three issues are particularly important when selecting the form of business entity for your new venture:
(1) Who will be the owner of the business?
(2) How will the earnings of the business be returned to its owners?
(3) Is the business expected initially to generate profits or losses?
This first post will look at the first of those issues – who will be the owners. In coming weeks we will also look at how will the earnings of the business be returned to its owners, and whether the business is initially expected to generate profits or losses.
If a business is owned by a few individuals, ownership isn’t as critical in choosing the business form, and factors other than ownership will be determinative. If the business will be widely held, the C-Corp. is usually the entity of choice for a variety of reasons. It has an unlimited lifetime and free transferability of ownership which is attractive to investors. An S-Corp. generally is not suitable for a widely held company because of limits on the types and number of shareholders.
If ownership interests in the business will be provided to employees, the C- Corp. is preferable for several reasons. Stock ownership is easy to explain to employees. Creating favorably priced equity incentives is easiest to accomplish via a C-Corp. because ownership can be held through various classes of stock. The tax laws give favorable treatment to incentive stock options (“ISO”) – as opposed to non-qualifying stock options (“NQS”) – granted by a corporation. While S-Corp.s can issue ISOs, the inability to have two classes of stock limit favorable pricing of the common stock offered to employees. While LLC memberships can be offered to employees, they are poorly understood and difficult to administer. LLC’s may not issues ISOs.
Holders of ISOs generally incur no tax until the shares purchased through an option are sold. The recognized gain is taxed at long-term capital gains rates rather than ordinary income. ISOs are only available for corporations. They are not available for partnerships or LLCs. When an option does not qualify as an ISO – and is thus an NQS – the holder recognizes ordinary income when the option is exercised and must pay tax on the difference between the exercise price and the fair market value of the stock at the time of exercise.
A business that expects to raise capital from institutional investors (including VCs) will usually organize as a C-Corp. because many institutional investment funds raise money from tax exempt entities such as pension and profit sharing trusts, universities and charitable organizations. These non-profits would incur unrelated business taxable income on which the non-profits must pay tax if the funds are invested through a flow-through entity like an LLC or S corporation.