In recent weeks, a number of clients that formed legal entities without consulting a professional adviser came to me and I determined that they had chosen an entity type that was not a good fit for them. So it’s worthwhile to take a few minutes to describe the main types of entities that typically are appropriate for a start-up business, along with information that may prevent others from choosing the wrong form.
The most common choices for an early-stage company are a limited liability company (“LLC”) or an S corporation (“S-corp”). These two structures are similar in one key aspect: they are both treated as “pass-through entities” for federal and state income tax purposes. This means that the entity files a tax return that is informational only; the entity doesn’t pay any tax itself, but rather its net taxable income or loss is passed through to the owners (the shareholders for S-corps or the members for LLCs). Those individuals report the income or loss on their personal tax returns, subject to various loss limitation rules.
This pass-through treatment is typically useful for the early stage company, which often has a loss for the first year of its existence or longer. As an LLC or an S-corp, the losses of the legal entity flow through to the tax returns of the members or shareholders, and they can use that loss to offset other income such as a spouse’s earnings, or earnings from consulting work or other outside employment that the entrepreneur performs to provide income while starting their business. There are, however, some limits in tax law on the ability to utilize loss, such as the passive activity loss rules, so obtaining advice from an attorney experienced in this area is key.
Beyond this basic treatment, however, LLCs and S-corps are different in many ways. For example, the Internal Revenue Code restricts eligibility to become an S-corp in ways that are not applicable for an LLC. For instance, an S-corp can only have 100 shareholders, and with a few rare exceptions all its shareholders must be individuals andU.S. residents. I have seen these requirements trip up unwary clients. Take for example the tech company with a CEO and CMO located here in the US and a CTO overseas, all of whom own equity in the company. That entity is not eligible to be an S-corp, although it is fully eligible to use the LLC structure.
In many cases, I see a bias among advisers and entrepreneurs to form an LLC. This is based partly on the limits mentioned above on S-corps, combined with the fact that LLCs generally offer a more flexible vehicle when it comes to allocating profits and losses among the stakeholders. However, an LLC is not universally the best choice for a start-up business. The following is not a complete list, but depending on the situation these are some possible advantages of an S-corp:
- The use of an S-corp can sometimes result in savings of social security taxes (but not income taxes), although proper advice and set-up is required to obtain those savings.
- Many investors prefer to invest in corporate entities rather than an LLC.
- An early stage company is often limited in its cash resources and wants to use some form of equity compensation to help it attract employees. However, once the company starts considering any approach more complicated than outright grant of an ownership interest such as options or appreciation rights, they discover that compensation of that type can’t be done under the LLC structure, or it involves legal and accounting complexities that will make it impractical for the business due to cost considerations. For this reason, one of the questions I ask clients before advising them on choosing their form of entity is what plans they have, if any, to grant some sort of equity compensation to their employees.
It isn’t possible to list all the advantages and disadvantages of each entity type in a short blog such as this. However, there is one other aspect of tax law that I should mention, which is what happens if the company decides in the future that it wants to convert to a different legal form. An LLC can convert to an S-corp on a non-taxable basis, but the opposite is not true. Yes, this is illogical, but no one ever accused the Internal Revenue Code of being logical. I represent a client that formed an S corporation but an investor requested that the company convert to an LLC. This conversion potentially would have created a large tax bill for the client. We were able to legally avoid any tax by a series of transactions that converted their S-corp to an LLC without incurring a tax bill, but it involved significant legal and accounting costs and delayed the transaction while those issues were addressed.
As another example of the levels of complexity involved here, another option is to form an LLC under state law, but under the IRS “check the box” rules elect to be treated as a corporation and then elect S status. In this case the entity is an LLC for state law purposes but an S-corp in the eyes of the IRS. This can also make sense in many cases, but the exact circumstances can’t be spelled out in a short blog such as this – another indication of the need for
Hopefully a theme has begun to emerge: there are many considerations that factor into making the right choice regarding types of entity, and it is easy to make a poor decision based on limited information or inaccurate assumptions. This is unfortunate, since an attorney who has the necessary experience can guide the client to the right entity quickly and easily. Think of it as low-cost insurance to make sure that the new company starts off on the right foot!
* I initially wanted to call this blog “Choosing a Legal Entity – Everything You Know is Wrong,” but I decided against it on the assumption that the Firesign Theater reference is obscure at this point.