WHAT LEGAL STRUCTURE IS BEST FOR MY BUSINESS?

I am often asked by clients and potential clients whether they need a formal legal entity for their new business, and which type—corporation or limited liability company (or “LLC”).  I have to give the lawyer’s favorite answer to that question:  it depends.

Factors to consider in choosing a legal entity

There are several factors to consider when choosing a legal structure for your business. These include:

• Tax impact on the business
• Will you be seeking outside investors, such as angels and venture capitalists
• Do you plan to issue equity, such as stock, and even go public some day
• Management structure: how will the business be run
• Liability issues

Operating a business without a formal legal structure such as a corporation or an LLC is called a sole proprietorship, and give you no shield against personal liability.  Unless your business is very small and very simple, at the very least you should have some form of legal entity in place to protect you from personal liability.

Following is a very brief overview of the main features of LLC’s, C corporations, and S corporations.  A full discussion would be an entire treatise and more!

Limited Liability Company (LLC)

A limited liability company is a type of business organization that offers its owners the same limited liability of a corporation. The LLC does not pay tax, however, like a corporation, but passes through its income and expenses to its owners (called “members”), who report their share of the gains and losses on their personal tax returns.

As with a corporation (see below), the members of the LLC are not personally liable for the LLC’s actions, but this shield is not absolute. If a member of an LLC commits a personal act that is negligent or illegal then the owner will be held liable. Also, if the members fail to treat the LLC as an entity separate from themselves (commingling funds, etc.), there could be personal liability.

LLC’s have become extremely popular forms of doing business in recent years.  In Colorado alone, the vast majority of new entities have been LLC’s rather than corporation, reflecting that most small businesses will remain private and closely-held, operated by the members. LLC’s are formed by filing articles of organization with the secretary of state or a similar office in the state where the members wish to form the LLC.

Corporations in General

 Like an LLC, a corporation is a formal legal entity, separate from its owners, or shareholders. Also like an LLC, a corporation can enter into contracts, employ individuals, and own real estate and equipment, among other things. A corporation also shields the people who own, control, and manage the company from personal liability. This means that if the corporation incurs a judgment against itself, the personal assets of the shareholders are protected.

Unlike LLC’s, which have only been around since the 1990’s, corporations have been around for centuries, and are commonly used when the shareholders want to raise larger sums of money from investors such as angels and venture capitalists by selling equity, or take the corporation public. Corporations are also governed by state law, and are formed by filing articles (sometimes called a certificate) of incorporation with the secretary of state or a similar office in the state where the corporation will be formed.

C Corporations

 The terms “C” and “S” corporations describe how a corporation will be taxed.  Corporations are governed by the law of the state where they are incorporated, but can elect one of two methods of being taxed by the IRS.  Unless a corporation makes what is called an “S election” with the IRS, it will be a “C” corporation, or “C corp.”

C corps and their shareholders are subject to what is sometimes called “double taxation.”  This occurs because a C corporation must file its own separate tax return and pay tax based on its net profit. Then, if it distributes after-tax income to shareholders through dividends, the shareholders are taxed again on an individual level.

C corps can have an unlimited number of shareholders, unlike S corporations.  This makes the C corp the preferred form if the founders hope to raise large amounts of capital, issue equity to investors, and perhaps be acquired or go public.

S Corporations

 S corporations do not pay taxes at the business level, as does a C corporation. Instead, S corporations must file a tax return but, like LLC’s, pass through any business income, losses, and expenses to the shareholders, who report this on their personal tax returns. Like LLC’s, S corporations are a good choice, for a smaller, privately-held company, and offer some tax deductibility advantages over LLC’s.  They do have several limitations on the number and type of shareholders, however; there cannot be more than 100 total owners, who are all U.S citizens or permanent residents. The shareholders cannot be other corporations, LLCs, certain trusts, investment funds or partnerships.

As you can see, choosing the right entity for a startup is an important decision, and can have real consequences for the business and its founders. An experienced business attorney can help you determine which form is best for your needs and goals.  If you have questions or would like more information, contact Mark Spitz by email at mark@spitzlegalcounsel.com, or phone/text at 720-575-0440.