Choosing an entity type for your new business is an essential step in the planning process. In good times, the proper entity type will inform your expansion and employee compensation options. In the unfortunate event that a lawsuit is brought against your business, having a company that is properly set up and well-maintained can help keep you from being held personally liable.
Each organizational form has its advantages and disadvantages. Owners should consider how these differences apply to their specific situation. There are three common choices: “C-Corporations,” “S- Corporations,” and, a favorite among lawyers, “Limited Liability Companies” (commonly known as LLCs). Before choosing, you should ask yourself the following questions:
C-Corporations are subject to what is called “double-taxation.” First, C-Corporations pay taxes on all profits that are not considered business expenses. Second, if the corporation distributes dividends to its shareholders, the shareholders are then required to pay taxes on those disbursements. In the end, the same income is being taxed twice, which may be unattractive to some business owners.
S-Corporations and LLCs, on the other hand, are “pass-through” or “flow-through” entities. This means that money (and taxation responsibility) flows through the entity to the owners. In other words, the owners are taxed, but the entity is not. Although both S-Corporations and LLCs are pass-through entities, S-Corporations are still required to file a business tax return, while LLCs only file a business tax return if there is more than one owner.
There is an additional option available for some businesses: eligible LLCs can elect to be taxed like an S Corporation. Eligibility requirements for “S” status include:
Of all the entities, C-Corporations grant the most flexibility in raising funds. C-Corporations can raise capital by issuing a potentially unlimited amount of shares to an unlimited number of investors. This is because C-Corporations have the unique ability to “go public.” If you plan on growing your company and taking its shares to be publicly traded on the stock exchange, then a C-Corporation may be the right choice.
LLCs are more flexible than C-Corporations but can’t go public. If you’re looking to keep your company privately-owned and raise money, which may include foreign investors, or have other entities as shareholders, an LLC could be the best option.
Nonqualified stock options and incentive stock options are two types of stock options that C-Corporations can issue to their employees. S-Corporations can also issue stock options, but these incentives are generally less common because S-Corporations cannot issue multiple classes of stock.
Profits interest grants—the equivalent of stock options for LLCs—are a less-known type of equity compensation. This type of grant is typically much more complex. It may require detailed agreements and revisions to the company’s operating agreement. The recipient is also treated as a partner for tax purposes with respect to the portion of the future profits and appreciation of the LLC’s assets from the date of its grant. This means that the recipient can no longer qualify as an employee for tax purposes and must file a Form K-1, and the company will likely invest significant time and resources in additional capital account maintenance work.
Every business’ needs are unique– which is why it is important to enlist the help of experienced legal and accounting professionals when making important decisions, like which entity type to choose for your company.