Determining the Best Legal Structure for Your Business
Q: What are the advantages of being an LLC over a sole-proprietorship?
A: There are four main factors to consider when an entrepreneur decides on the form of organization that best fits her business: taxes, limitation of personal liability, ease of transferability and admission of new owners and investor expectation. In almost all cases, I recommend that a founder form her business first as a limited liability company (LLC) and that she plan to convert to a C corporation immediately before taking institutional investment (money from a venture capital firm, in many cases.)
The process can be a difficult one, because there are so many forms of organization from which to choose. A business can be organized as a sole proprietorship, a general partnership, a limited partnership, an LLC, a “C” corporation, an “S” corporation and, just to add one more level of complexity for companies in Massachusetts only, a Massachusetts business trust. Each type of organization has its own advantages and disadvantages, and I will run through a couple of the highlights here. (I left Massachusetts business trust out of this post.)
Because each state has its own tax structure, I will focus here on federal-level taxes only.
Sole-Proprietorship. A sole proprietorship is the easiest type of business to organize. The founder must simply apply for the required licenses to do business in her jurisdiction and away she goes. A sole proprietor can even use her own social security number and need not apply for a federal taxpayer identification number. Tax reporting is easy: Simply report the company’s income and expenses on a form (Schedule C) that the founder will attach to her annual tax return.
Unfortunately, a sole proprietor is 100 perecent personally liable for all the company’s debts and obligations. This includes vendors, taxes (payroll and otherwise), loans and even lawsuits. Moreover, it is impossible for a sole proprietor to transfer an interest in her company and remain a sole proprietor by definition. In my view, the risk here far outweighs the benefit, and I almost never urge a founder to start her business as a sole proprietorship.
Partnership. A general partnership is easy to form and operate. However, it also provides no liability protection for the partners. Each general partner is completely liable for the debts of the partnership.
In the case of a limited partnership, the LPs are not liable for debts of the partnership. However, a limited partnership can be very complicated from a tax perspective (Subchapter K of the Internal Revenue Code is probably the most complicated section) and can be cumbersome from which to operate an ongoing business. Further, because each limited partnership must have a general partner who will be personally liable for the company’s debts, someone may get stuck holding the bag at the end of the day. While many venture capital and other funds are themselves formed as limited partnerships, operating companies are typically not so organized. Lastly, because the partnership tax rules do not easily lend themselves to special allocations among partners, I almost never urge a founder to start her business using a general or limited partnership.
Corporation. A corporation can provide protection to a founder against the liabilities of the company. If managed properly (e.g., setting up a separate corporate bank account, not paying personal expenses through the corporation, having the corporation’s board of directors authorize certain corporate actions) the corporation can protect the founder.
There are two types of corporations -- based upon how the corporation will be taxed. A S corporation will not pay any federal corporate-level income taxes. Instead, the profits and losses of the corporation will be reported on the individual tax returns of the shareholders. A S corporation has some other restrictions, however, that make it less attractive. It can have only up to 99 shareholders, cannot have certain types of shareholders including limited partnerships and can have only one class of stock for economic allocations. (A S corporation can have more than one class of stock so long as the only distinction between the classes is voting but no liquidation preferences that investors often expect.)
A C corporation is a bit more flexible, in that it can have an unlimited number of shareholders and can have any number of classes of stock while still providing the limited liability provided by an X corporation. However, because a C corporation is a separate tax-paying entity, it may result in double taxation of a corporation’s profits -- once when the corporation earns the profit and again when the shareholders receive the distribution as dividends or as a liquidating distribution. While not ideal, however, many investors insist on a C corporation. (More on that later.)
Limited Liability Company. A hybrid form of organization, a limited liability company (LLC) provides the limited liability protection of a corporation, while avoiding the double taxation. Because it is taxed like a partnership, it can be more flexible than a corporation. Seems like the best of all worlds and for many operating companies, it is. For many companies that will not seek venture capital or other substantial outside financing, an LLC should be the form of organization of choice, and for those that will seek outside funding, I often suggest they start as LLCs and convert to C corporations immediately before the funding comes.
However, many investors do not like to invest in LLCs. First, investing in an LLC can create unintended consequences under Employee Retirement Income Security Act (ERISA) for pension funds who may have invested in the fund making the investment. As a result, many funds are prohibited by their governing documents from investing in an LLC. Second, venture capital and other funds do not want to wait for a portfolio company to finish its own tax return and issue K-1s to its members before the fund can do its tax return and issue its K-1s to its investors. And finally, there is a significant tax incentive to investors who invest in “qualified small business” stock, which requires that the company receiving the investment be a C corporation.
After all that, let me cut to the chase. While there is no one-size-fits-all solution, I commonly recommend that founders start their business as an LLC and convert to a C corporation immediately before they receive substantial outside funding. For a detailed explanation of why, please see this post I penned last year.
Finally, I have focused here on general advice, and I urge you to consult with your own attorney and accountant for the form of organization that best fits your individual needs.