Should Your Startup be a Partnership, LLC, S or C Corp?
At KENOVA we use the phrase 'business sequencing' to describe the process of executing business activities in the correct order. So, if you need to offer equity to investors, partners, employees, etc., one of the first business activities in your sequence is to establish a legal business entity. The question is, what form should you use? The following blog is written by contributing blogger Carl Kemph of the Law Offices of Carleton R. Kemph.
Presently, there are the following formats available to a startup business:
“C” corporation – This is the “basic” form of corporation commonly utilized by public companies listed on stock exchanges. It provides some degree of insulation from personal liability and is subject to federal “double taxation” – i.e., profits are taxed at the corporate level and dividends to shareholders are again taxed as income.
“S” corporation – This is an option that can be elected subject to certain conditions. It provides some degree of insulation from personal liability but reduces or eliminates “double taxation”.
Partnership – General partnerships provide no insulation from personal liability. Limited Partnerships provide insulation from personal liability for certain “limited”) partners who are generally investors with no management role. Under certain conditions, the “general” partner(s) can be incorporated, largely eliminating exposure to personal liability. Generally speaking, partnerships are not subject to multiple levels of taxation.
Sole Proprietorship – this is simply opening a business as an individual. It affords no insulation from personal liability and there is no exposure to double taxation.
Limited Liability Company/Partnership – this is the most recently form of entity, created state-by-state and now dating back decades. The essential purpose of the LLC is to afford an entity that insulates against personal liability, has a single level of taxation and profoundly simplifies the ongoing entity requirements.
For most of the twentieth century, startup enterprises were compelled to choose between avoiding personal financial liability on the one hand and federal income tax advantages on the other. By this we mean that the Internal Revenue Code enforced a policy imposing a second tier of taxation on entities insulating principals from personal liability. The LLC format was specifically designed and implemented to blend insulation from personal liability with a single tier structure. Additionally, the state statutes that created these entities did away with much of the obsolete housekeeping and maintenance required by the corporate format.
Compared with corporations, LLC’s are structurally quite similar. In lieu of shareholders LLC’s are owned by “members”. In lieu of stock they issue interests, which can be certificated just like shares in a corporation. There are managers rather than a board of directors, and there is no need for officers such as a president, vice president, secretary and treasurer. LLC’s can be governed via an “operating agreement”, which serves much as a partnership agreement governs partnerships. Routine management, equity calls, distributions and transfers of interest are governed in much the same manner as a shareholders agreement governs a corporation. In terms of ongoing entity housekeeping, LLC’s are more similar to a partnership, and typically impose no obligation to hold annual meetings, elect a board, install officers and so on.
Finally, while “Wall Street” does have a historical predisposition favoring the corporate format in the context of a public offering, many states have statutes that are extremely accommodating regarding merger-conversion from LLC to corporation when the situation becomes ripe.
Bottom line: In our view this format offers protection, federal tax efficiency and simplicity in the legal formalities surrounding attendance to routine operation of the entity.
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* This article provides a generic overview as a beginning point for selecting the entity format you deem desirable for formation of a company through which to start your business. The foregoing does not constitute legal or any other advice, and you cannot rely upon it as such. Complete counseling in this area requires extensive discussion and analysis of specific circumstances, objectives and the like, in consultation with an appropriate group of advisors having the necessary specialties, and who are licensed in the germane jurisdictions.
Law Offices of Carleton R. Kemph
~ Counselor at Law ~
Business • Real Estate • Property Tax Appeals
6 Hampshire Court
Springfield, NJ 07081