Entity Considerations for the Entrepreneur

by Tyler Eathington
Quinn, Johnston, Henderson, Pretorius & Cerulo

There are many issues an entrepreneur should consider when deciding on the choice of entity.

One of the most important decisions an entrepreneur can make regarding their startup business is deciding the entity for their venture, as this will impact all future decisions. Each business endeavor is unique, and the keys to its success depend on the needs of the venture.

There are many issues an entrepreneur should consider when deciding on the choice of entity. For example, is my business in a high-risk market such as real estate, where I need to personally shield myself and others from liability? Or will my business be in a market where there is less risk, such as consulting? Since every business has different issues to consider, the pros and cons of each entity should be weighed against the needs of the business to help facilitate long-term growth and success.

Initially, an entrepreneur is focused on his or her startup business, and the choice of entity is a lower priority. However, the entity he or she selects can have a profound impact on future success. The following entities are generally the best options for startups.

C Corporation
Corporations are separate legal entities created under state laws. Thus, a corporation has a separate legal existence from its owners.

The pros:

  • Venture capital funds typically will only invest in C corporations. This is because venture capital funds avoid investing in “pass-through” entities for tax purposes.
  • C corporations protect against personal liability if all corporate formalities have been complied with. The corporation is a separate legal entity and responsible for its own debts. Therefore, the shareholders, directors or officers will typically not be liable for such debts.
  • They also offer a flexible capital structure. C corps may have different classes of stock. This flexibility gives a C corporation a significant advantage in raising capital.
  • As a separate legal entity, a corporation can continue indefinitely.

The cons:

  • Subject to double taxation. The corporate profits are taxed twice, and the losses do not pass through to the shareholders.
  • Corporations have to comply with significant formalities under state law. In Illinois, a corporation can be created only by substantial compliance with the Illinois Business Corporation Act of 1983 or the corporation law of another state, which generally requires filing articles of incorporation containing certain essential provisions, payment of certain fees, and numerous other formalities.
  • Additionally, a significant amount of recordkeeping is required to maintain status as a corporation.

A C corporation is a good option for startup businesses. The corporate structure allows the business to raise additional funds, issue stock or other securities, and provide liability protection.

S Corporation
The formation and maintenance of an S corporation is similar to the C corporation. However, the shareholders must make a special federal income tax election to be an S corporation and meet certain technical requirements, including the following:

  • The number of shareholders may not exceed 100.
  • The corporation is limited to issuing one class of stock.
  • All shareholders must be individuals, estates (for a limited period) or certain defined trusts. Corporations or partnerships cannot be shareholders.
  • Must be filed as a U.S corporation.

The S corporation does not pay tax, but the income is passed through to the individual shareholders. It is extremely important for the shareholders in an S corporation to have a shareholder's agreement to prevent the S corporation status from terminating.

The pros:

  • S corporations protect against personal liability if all corporate formalities have been complied with by the corporation. The corporation is a separate legal entity and responsible for its own debts. Therefore, the shareholders, directors or officers will typically not be liable.
  • Pass-through tax treatment. Investors may find this appealing because any losses can be written-off.
  • As a separate legal entity, a corporation can continue indefinitely.

The cons:

  • Limitation on the number of shareholders and who can be shareholders.
  • Corporations have to comply with significant formalities under state law.
  • Additionally, a significant amount of recordkeeping is required to maintain status as a corporation.
  • Difficult ownership requirements and rules to comply with.
  • VC funds typically do not invest in S corps.

The S corporation is ideal for any business which would like to shield the owners from personal liability and is looking to take advantage of anticipated losses. Many startups and entrepreneurs should consider an S corporation as an entity. While the S corporation may not initially be attractive to VC investments, transitioning from an S corp to a C corp is not difficult.

Limited Liability Company
LLCs are generally described as a hybrid between a corporation and a general partnership. The LLC is a business entity which allows investors to combine many of the tax and management features of the partnership with the limited liability protection of the corporation. The LLC also eliminates the frustration many new businesses have experienced trying to comply with the S corporation ownership requirements in order to take advantage of limited liability.

The pros:

  • The LLC allows owners maximum flexibility with respect to management and control of the company. The LLC is relatively easy to organize and maintain.
  • The LLC enables equity owners to enjoy both limited liability and flow through income and losses treatment.
  • An LLC has none of the drawbacks associated with the S corporation ownership qualification. There are no restrictions with respect to the number or type of members. This flexibility in ownership will likely be attractive to foreign investors seeking to conduct business in the U.S.

The cons:

  • LLCs are complex from a tax and accounting perspective, and are generally governed by partnership tax rules. Compliance with these rules may be costly.
  • As a pass-through entity for tax purposes, VC funds typically will not invest in LLCs.
  • A limited liability company is a good option for companies looking for personal liability protection and pass-through taxation but not looking for venture capital funding.

Conclusion
Startups should consider carefully the choice of entity for their business. There are several factors that should be considered in making the choice and the entrepreneur should seek sound legal, accounting and tax advice when making the decision. iBi

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