Entity Selection for Startups
Entrepreneurs will face a huge number of decisions as they move from concept to commercialization. One of the first major decisions is what type of legal entity to form in order to move their great ideas forward. Why does it matter? Because different entities have very different rules regarding limited liability, management and control flexibility, capital structure, tax efficiency and eligible investors.
A sole proprietorship is not a separate legal entity. You simply start doing business, and you are a sole proprietor. A sole proprietor makes all the decisions and has total control over the business. Because there is no separate entity, the entrepreneur directly pays any tax liabilities related to the business. Similarly, because there is no separate entity, there is no limited liability, meaning the founder is personally responsible for all liabilities of the business, including liabilities incurred as a result of acts committed by employees of the sole proprietorship. This means that all of the founder’s personal assets are subject to claims by creditors of the business to efficiently and effectively deal with any breaches or compromises that occur.
Similar to a sole proprietorship, there are no formalities to forming a general partnership. A general partnership is an association of two or more people carrying on a business for profit as co-owners. While a written partnership agreement or a state law filing is permitted, it is not necessary to form a general partnership. Unfortunately, founders can therefore find themselves in an accidental partnership. In the absence of a partnership agreement which might contain restrictions, each partner in a general partnership can bind the partnership. Similarly, each partner is therefore liable for all the debts and obligations of the partnership as well as the acts of each other partner, meaning there is no limited liability.
The general rule for partnerships of all types is that rather than paying separate taxes, profits and losses flow through the business to the partners in proportion to their ownership, regardless of whether the partnership distributes cash or property to the individual partners. While the partnership will file a notice return, it will not be separately liable for taxes. One concern this raises for investors is the possibility of “phantom taxes” where they are forced to recognize their proportion of the profits, even though the business has not made distributions.
A limited partnership is a partnership formed by two or more people that has one or more general partners and one or more limited partners. It may only be formed by making a state level filing. The general partner deals with daily operations and responsibilities and remains liable for all of the debts, obligations and liabilities of the partnership. A limited partner’s liability for the partnership’s debts and obligations is limited to the amount of money or property that such limited partner contributed to the partnership, provided the limited partner doesn’t participate in the control of the business. As in all partnerships, there is no entity level taxation. Limited partnerships offer significant flexibility regarding allocations of profits and losses.
A corporation is a separate legal entity that provides limited liability protection to its stockholders, officers and directors. Unlike a general partnership or a limited partnership, neither the management nor the owners have unlimited liability. Also, unlike partnerships, there is a clear delineation between ownership and control. The stockholders elect the board of directors, and the board of directors controls the business through the officers and management. In order to preserve the limited liability protection, however, corporate filings and formalities must be observed.
Many entrepreneurs find that their biggest concern in using a corporation is that the corporation is subject to a separate and second level of taxation. Profits are taxed first at the corporate level at corporate tax rates, and then, again, at the shareholder level at ordinary income rates, if and when distributions are made. One reason that early stage high growth investors don’t fear this “double taxation” is that they often sell their equity in the corporation during a phase in which the corporation is not producing net income. Additionally, the sale of their equity is taxed just once, and at more favorable capital gains rates.
Entrepreneurs typically utilize corporations because, thanks to a well-developed body of statutory and case law, they are predictable and well understood by founders, management and investors. They also are flexible and allow a complicated capitalization table with multiple classes of stock. These two features, along with the elimination of phantom tax risk, make corporations the entity of choice for angel and venture capital investors.
A corporation that has not made a Subchapter S election under the tax code is often referred to as a “C” corporation.
An “S” Corporation is an ordinary corporation that has elected under Subchapter S of the tax code to be treated as a partnership. Like a normal partnership, there will be no entity level taxation, rather profits and losses will flow through and be recognized directly by stockholders. There are specific rules to qualify as an S Corporation:
• No more than 100 stockholders.
• All stockholders must be U.S. citizens or residents
• All stockholders must be natural human beings (and certain trusts)
• Only one class of stock (can’t have both “common” and “preferred”)
An S Corporation that no longer meets the requirements due to a change in circumstances, a preferred stock financing by way of example, will no longer be treated as an S corporation from the date of such change. Many entrepreneurs often make the subchapter S election if early investors can use their share of the losses and the general benefits exceed the costs of filing two tax returns.
Limited Liability Company
A limited liability company (“LLC”) combines the best attributes of partnerships and corporations: limited liability and tax flexibility. An LLC is a separate legal entity that is owned by its members and that may be directly managed (“member managed”) or indirectly managed (“manager managed”). An LLC may have a written operating agreement that governs the operation of the organization. In the absence of a written operating agreement, default provisions call for member voting in accordance with capital contributions. An LLC provides limited liability protection to its members and managers. LLCs permit varying classes of economic and voting rights with no limits on the number or kind of members. They have the added benefit of the use of “profits interests” for equity incentive purposes, wherein a holder participates only in the future appreciation of the company but has no rights to the value of the company as of the date of issue.
Like a partnership, there is no entity level taxation and profits and losses flow through and are recognized directly by members. LLCs are permitted to specially allocate profits and losses among their members, but there remains a risk of phantom income tax gains. This is often a very attractive structure if the business will take in and distribute to its members royalty type revenues, particularly if there is not a significant market for the equity of the business itself.
LLCs are relatively new entities with a less established, and therefore less certain, body of law. The significant flexibility of LLCs means they are often more complex and more expensive to set up. Investors sometimes disfavor LLCs as a vehicle for investment because of their complexity. LLCs can be a good choice for those organizations that seek flexibility and passthrough tax treatment and don’t anticipate high growth funding in the immediate future.
A benefit corporation is a corporation formed to further both specific public benefits and shareholder profit. Massachusetts is one of a relatively few states that have adopted benefit corporation statutes. Directors of a benefit corporation are expected to consider priorities beyond shareholder value, including employees, the environment and the community. Benefit corporations face significantly higher administrative burdens, including increased reporting requirements and higher standards of transparency. It is still unclear whether organizing as a benefit corporation has significant advantages in helping a business secure grants, obtain program related investments, or attract customers.
As you might expect, there is no single entity choice that is best for every organization. While corporations are a good choice if an organization anticipates outside funding events in the early stages of growth, LLCs may be the best choice for those seeking favorable tax treatment, limited liability, and significant flexibility with respect to ownership, management and capital structure. A thoughtful consideration of your circumstances, priorities and realities can help you make an informed choice.
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This article was prepared by Jeremy Halpern, partner and co-chair of the Emerging Companies Group at Nutter. For more information, please contact Jeremy or your Nutter attorney at 617.439.2000.
This article is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising. © 2017 Nutter McClennen & Fish LLP.