Pick a structure for your startup
As an entrepreneur launching your business, you know there’s a lot to do: decisions to be made, contracts to be signed and a business to be launched. But is choosing the correct business entity a priority on your to-do list? Probably not—but it should be.
Choosing the right business entity is essential to launching a successful enterprise. It’s the difference between being held liable for business-related losses or walking away with your personal assets intact. It could affect the taxes you pay or how you exit the business, among other things.
Let’s start with the basics. There are four primary business structure types: C-corps, S-corps, partnerships, and LLCs; the latter three are collectively known as pass-through entities.
Here we will discuss the pros and cons of the different business entities, and you’ll see that LLCs emerge as the preferred choice for most entrepreneurs, due to their flexibility and tax structure.
1. Liability limitations Depending on which structure you choose, you can be held liable to various degrees for legal troubles related to your business. With C-corps, S-corps, and LLCs, your personal liability exposure is limited to the amounts invested and loaned to the entity (including debt guarantees). With a partnership, there is unlimited personal liability for general partners, a major drawback.
2. Startup losses One of the keys to success for a business is the availability of cash in the business’ infancy. If you suffer startup losses, they can be deducted at the owner level with pass-through entities to the extent of the owner’s investment. You can use those startup losses against your personal income to generate an immediate refund and enable you to monetize that operating loss. However, with a C-corp, startup losses cannot be deducted against personal income, only against corporate profits. For purposes of deducting losses from the entity, a partnership or LLC owner generally receives basis for all capital contributions, direct loans to the entity, loans guaranteed by the owner, and his share of qualified mortgages on real estate. An owner of an S-corp, however, only receives basis for capital contributions and direct loans to the entity.
3. Capital-raising plans In the past, venture capitalists and equity funds almost exclusively worked with C-corps, but that’s changing. Many venture capitalists now are accepting of pass-through entities. If you plan to raise capital from venture capitalists, you don’t necessarily need to be a C-corp. If you are a pass-through entity and venture capitalists are unwilling to work with you, it’s very easy to change over to a C-corp structure. Switching from a C-corp to a pass-through entity, however, is more complicated and often will have tax consequences. An LLC (or partnership) has the ability to specially allocate income and losses to its owners. This is beneficial to investors who aren’t directly participating in management, but have significant capital invested. Such investors will expect a preferred return on their investment before the “sweat equity” owners may receive any income. S-corps cannot accommodate such an arrangement. S-corps are also limiting because they are constrained to certain types of owners, primarily individuals. A venture capital group organized as an LLC could not invest directly in an S-corp.
4. Tax rates For businesses that operate as a pass-through entity, owners are taxed at their individual marginal tax rates, while C-corps pay their own income tax. Currently, the highest marginal tax rates for both individuals and corporations are 35 percent. If the tax rates are the same, what difference does it make? C-corps are subjected to double taxation—the profits of a C-corp are taxed, as well as dividend distributions to owners. In contrast, income from pass-through entities is taxed once. The entity pays no tax. Instead, the owners pay the tax and generally take tax-free dividends from the entity to the extent of the income generated. The tax savings can be significant on an annual basis, but the avoidance of double taxation pays off when the business is sold.
5. Exiting the business As stated earlier, you have a lot on your plate as someone just starting a business. But let’s add one more thing to your to-do list: thinking about exiting the business. Sounds premature, but it’s never too early to start planning your exit.
Generally, exiting an LLC is an easy process if you set up a flexible operating agreement. In your operating agreement, you should include details to accommodate and outline the process for a variety of exits like selling or transferring the business. Hopefully by now you see why an LLC is so common and popular among entrepreneurs. They possess the qualities you likely want for your business—the ability to deduct startup losses immediately, flexibility in structure and ownership, the chance to raise capital, and no personal liability at stake. Remember that choosing a corporate structure is a very important decision, so don’t be afraid to consult attorneys, accountants, and other qualified professionals throughout the process.