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What type of legal entity structure should I form?

Jan 19, 2021

Start-up founders have countless decisions to make. Of all those decisions, one of the most important is the type of legal entity to form. The debate is typically between becoming a limited liability company (LLC) or a corporation — the two most popular structures for early-stage businesses. What's the difference between the two? And what are the relative merits of each?

Understanding the basics of LLCs and corporations

When it comes down to LLCs versus corporations, there are a few basic differences.

LLCs offer personal liability protection, no limit on the number of members allowed and flexibility in profit allocations between members. Their leg up on corporations is their ease of formation. It's a simple one-step registration process.

Corporations also offer liability protection, do not limit the number of members allowed and provide flexibility in profit allocations between members. However, they generally have more formal record-keeping and reporting requirements than LLCs. Changing the asset and debt structure, for example, involves public filings to amend organizational documents. Despite the added complexity, many entrepreneurs select this structure because it is generally preferred by venture investors.

What structure means for taxes

The decision of entity structure does not end there. After you decide between LLC and corporation, you need to consider whether to be treated as C corporation, S corporation, partnership or sole proprietorships.

A C corporation is taxed separately from its owners; an S corporation, LLC partnership or LLC sole proprietorship is not. That's why you hear the latter referred to as pass-through entities: the taxation is passed to the owner.

For tax purposes, the IRS considers an entity structured as an LLC with one owner as a sole proprietorship (a.k.a. disregarded entity). It considers LLCs with more than one member as a partnership.

A sole proprietorship is the simplest and most popular type of LLC. Sole proprietor entities pass income and losses to the owner, reported on their personal income tax return. The owner's income is taxed at the individual owner's potentially lower marginal tax bracket. Losses, on the other hand, may offset the owner's nonbusiness income.

Partnerships provide the most flexibility of ownership, allocation and transaction planning. Trusts, non-US residents, S corporations and C corporations can all be part of a partnership. Partners can generally allocate their income or losses as they see fit. In most cases, they can receive distributions without any immediate tax due. However, the partner's share of the business income is subject to self-employment taxes.

When is an LLC a corporation?

Whether a sole proprietorship or a partnership, an LLC can elect to be treated as a corporation. You might want to do this to keep profits in the LLC, especially if you are looking to grow. You, or you and your members, can take a W-2 salary instead of profit distribution.

An entity structured as a corporation or electing to be treated as a corporation is considered a C corporation. With C corporations, income and losses are reported and taxed at the corporate level. If profits are distributed, they are characterized as dividends. Shareholders report the dividends on their individual income tax returns. In short, the IRS taxes C Corporation income at both corporate and personal levels.

That said, and to make things a little more confusing, any corporation can elect to be treated as an S corporation. As an S corporation, a business's income and losses pass through the shareholder level to the owners. The owners pay taxes only once on the pass-through income, which they report on their personal tax returns (thus, subject to the personal marginal tax rate).

While the tax benefits might be appealing, S corporations have several disadvantages. For example, profits and losses are allocated based strictly on the percentage of ownership or number of shares held. Additionally, there are limitations on the number of shareholders as well as the type of shareholders:

  • Only individuals, certain estates and trusts, and specific tax-exempt organizations can be shareholders.
  • There cannot be more than 100 shareholders, with a possible exception for family members.
  • Only one class of stock is allowed (although there may be differences in voting).

In the end, the decision about which legal entity to form comes down to the number of owners, how they want to be paid, and how they want to be taxed.

Still not sure which legal entity to choose?

You don’t have to make this decision alone. We’d be happy to walk you through the decision process. Contact us. To see how our team can helps yours, see our web page for startup companies.

Or learn more with these additional resources:

SOC exams benefits for blockchain start-ups

How R&D tax  credits can help start-ups

How to position your start-up today for recovery

Author(s)

Ronald O. Bote, CPA, MST
Manager
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