Ask the Advisor is a weekly PaySimple column featuring reader-submitted small business questions answered by our panel of business professionals. If you would like to submit a question, or become a PaySimple business advisor, please read the information at the bottom of this article.
This week’s question is answered by Jedediah Ande, Partner, and Matthew Uretsky, Associate, of the SorinRand Law Firm.
“How do I choose which type of business entity is right for my new venture?”
One of the first and most important choices an entrepreneur must make when starting a new business venture is what legal entity to use for the new company. In answering this question, an entrepreneur must consider a multitude of issues, such as minimizing taxes, limitation of personal liability, financing strategy and business management. As counsel to start-ups in a variety of markets, we consider the relevant facts for each entrepreneur and assist him or her in making the proper choice of legal entity for their new venture. Today, most new businesses are structured as corporations or limited liability companies.
A corporation is a separate legal entity, governed by the laws of its state of incorporation. Historically, most corporations were formed under Delaware law although other states, such as Nevada and Wyoming, are gaining in popularity. Delaware law is still regarded as the most developed body of corporate law, and the law with which investors (especially venture capital firms) are most comfortable. Corporations provide the benefit of limited liability to stockholders, meaning that investors generally stand to lose only their investment amount and are not responsible for company debts. For corporations which desire to incentivize their employees through equity compensation, it is simpler and more tax-advantageous to issue options and restricted stock than similar equity interests in limited liability companies.
On the other hand, because a corporation is a distinct legal entity, all corporate income is taxed when received by the corporation and taxed again, a second time, if and when distributed to the stockholders. This issue of double taxation can be eliminated if a corporation elects to be treated as an “S-corporation,” but S corporations are subject to certain specific requirements, such as stockholder eligibility requirements and limited number of stockholders.
Limited liability companies (LLCs) provide some of the same benefits as the corporate form, such as limited liability of equity holders. LLCs, however, are more flexible than corporations in many respects; for instance, LLCs permit much greater discretion with respect to distributions of profits, management and allocations of profits and losses. Additionally, an LLC is a “pass-through” entity (unless the equity holders elect otherwise), meaning that profits and losses flow through to the individual equity holders, eliminating double taxation and allowing equity holders to take advantage of early-stage losses for tax purposes.
While venture capital firms do not generally invest in LLCs, a small minority of today’s firms do. Typically, however, most venture firms will require an LLC to become a corporation (either via conversion or merger) prior to making an investment, which can add additional time and expense when a company needs to obtain additional capital quickly.
The decision as to which legal entity is best for an entrepreneur is a fact-specific determination. Given the business, legal and tax implications involved, we suggest that entrepreneurs discuss these issues with their legal advisors prior to making this decision. Entrepreneurs who select the appropriate legal entity when starting their business venture can reduce time, cost and future headache, and position their venture for success.
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