When you are planning to start a new business, one of the first things you must consider is the form, or business entity, you will use.
There are a few basic types of business entities, each one suited to different plans and circumstances:
Sole Proprietorship — this is the simplest form; there is no entity to be formed — it is just you. Which means that if something goes wrong and you get sued, all of your personal assets could be seized to pay a judgment against you.
The only paperwork required here is if you use a name other than your own — “Connie’s Coding Company” for example — which requires a filing with the county and/or state in which you’re going to be doing business.
The profit or loss is shown on a page — Schedule C — of your tax return, and included directly in your income.
General Partnership — in this form, you and one or more others agree to join together to carry on a business. In many states, this entity has to be at least registered with the state, and a separate tax return has to be filed each year. But the entity itself does not pay income tax. Each partner’s share of profit or loss is passed through and included in his, her, or its income tax return.
A general partnership is very flexible — you can arrange it so that profit or loss flows any way you and your partners can agree. For example, in a typical partnership in which one person furnishes the money and the other the work, frequently the “money” partner gets all or part of his or her investment back first. And there are an infinite number of other arrangements.
Another advantage of a general partnership is that any person — an individual, corporation, trust, a hedge fund, a nonresident alien — can be a partner. As we’ll see later, not every business entity can do this.
In a general partnership, unless the partners agree otherwise, every partner gets a vote.
There is one big drawback to a general partnership, however — every partner’s assets are liable for any judgment. This is why this type of entity is rarely used for new businesses.
Limited Partnership — this entity is called “limited” for two reasons:
First, because you can limit your investors’ risk to the amounts they put in. In other words, there is nothing the limited partners can lose except their investments — their other assets are not up for grabs. That still leaves you and any other working partners, or general partners, at risk in case something goes south.
The second reason is that the limited partners normally have no voting rights — all business decisions are made by the general partner or partners.
This entity also requires registration with the state and the filing of a separate tax return. In many states, California for example, an annual minimum tax payment is required.
Limited Liability Company — the limited liability company, or LLC, has become the preferred startup business entity.
This is because it combines the flexibility of a partnership with full liability protection for all partners (or members, as they are called). In other words, the assets of no one — not the general (here called managing members) nor the non-managing members — beyond what the members have invested in the LLC may be attached in a lawsuit.
This entity, too, requires registration and files a separate tax return that passes income or loss out to the members, although the entity also may have its own state tax liability.
S Corporation — This was formerly the most popular entity for a startup. Before the invention of the LLC, it was the only entity which provided complete liability protection and pass-through of profits and losses. (Although some states, again California among them, do impose a small state tax on S corporations.)
But it had limitations which make it unsuitable for use by a startup under today’s conditions:
First, only U.S.-resident individuals (with a couple of minor exemptions for their trusts) could be shareholders in an S corporation — no partnerships, no funds, no corporations, no tax-exempt entities, no nonresident aliens.
Second, the maximum number of shareholders in an S corporation was originally limited to 100 (now 300). Finally, the flexibility of a partnership in distributing profits and losses is not available — every shareholder must get the same per-share distribution and at the same time. This is called the “one class of stock rule” and, except for allowing non-voting shares, it is completely inflexible.
C Corporation — This form of business entity is almost never used in a startup situation.
The C corporation has a lot of benefits: it protects its owners against liability for corporate actions, it can have any type or number of shareholders, and it can have many different classes of stock with varying distributions.
But it is not favored because, unlike all the other entities, it is a separate taxpaying entity; that is, it has its own profits and losses, pays its own taxes, and does not pass-through losses or profits.
Since most startups lose money in their initial years, the investors generally want to have the benefit of those losses to offset other income, or to receive profits without the interposition of a corporate-level tax.
Even if an IPO or acquisition is anticipated as the equity event, an LLC or S corporation can be converted to a C corporation literally overnight.
Thus, the only beneficial time to be a C corporation is after the business has passed its loss period and before it reaches the point of having more profit than it needs for business growth. Since this is generally a short period, electing C corporation status is almost never a good idea.
In conclusion, there you have the good, the bad, and the ugly of business entities as they pertain to startups. Please remember that this article is not tax or legal advice and cannot be relied on to be suitable for your circumstances. CONSULT YOUR TAX ADVISOR BEFORE DOING ANYTHING!
— February 22, 2016