How to Choose a Business EntityWhat is the difference in all of the available entities? Which is the best for my company? Why is Delaware so popular?
There are a select few corporate entities types that are used in the United States, and you’ve most likely dealt with each form in one way or another before. Each type of entity has its own advantages and disadvantages — in terms of tax, personal liabilities, future fund raising factors and so on.
First, it is important to understand what a corporation is and also what purpose they have in operating a business. A corporation is a legal entity that can enter into contracts, own property, and be a party in a court. It comes in assorted sizes, from publicly held to one person businesses. The beauty of a corporation, is that no two are alike. It is a legal construct which gives business participants significant freedom in choosing their own customized relationships. That is why it is important to have a general idea of the benefits and disadvantages of each type to fit into your specific scenario. Each state has their own (often similar) statutory framework for their corporations' operations. However, there is room outside of the framework to run a corporation.
The Limited Liability Company
A hybrid entity between a Partnership and a Corporation. Members are not personally liable for the debts of the LLC entity. As far as tax implications, LLCs have the choice to be taxed as a flow-through entity. The LLC is much simpler to run compared with a corporation. While a corporation requires a board of directors, officers, regular director's meetings and shareholder's meetings, an LLC does not require these formalities. It can be run day-to-day as though it were a partnership, even though it has some of the liability and tax protections of a corporation. In its Operating Agreement, an LLC can determine how to distribute profits in proportions other than investment percentages. Additionally, an LLC doesn't have restrictions on the type and number of partners the way an S Corporation does. In fact, your members can even be foreign nationals or other companies, with no limit on the maximum number of members.
The C Corporation
A C corporation is the default corporate structure. A C corporation is taxed separately from its individual owners, which means its profits are taxed through the corporation and the owners only pay taxes on the income they receive from the corporation. Additionally, if the owners also make profits from the corporation in the form of dividends, these profits are also taxed as income, even though they have already been taxed through the corporation. This taxation system is often called double taxation. This corporate structure applies anytime a business owner decides to form a corporation unless filing for S corporation status. While double taxation may seem like a drawback, don’t be so quick to dismiss this type of entity. There are benefits to the C corporation. It can be easier to build capital with a C corporation because the taxes on the corporation are lower than individual income taxes and as long as the dividends stay within the corporation, this can quickly accumulate into capital for the corporation. Under the C Corporation, owners can provide generous benefits to employees, which are tax-free to the employees and are write-offs for the corporation. Moreover, foreign residents and nationals are allowed to form C corporations in the United States and any type of business can become a C corporation.
The S Corporation Status
The IRS allows certain corporation to elect flow-through tax treatment. It is not subject to any entity tax, and all corporate income, losses, deductions, and credits flow through to the shareholders. However, to be eligible here are the main S corporation limitations:
- It must be a U.S. corporation.
- It must have no more than 100 shareholders. However, all members of a family are counted as a single shareholder. Spouses are also counted as a single shareholder.
- Its shareholders can only be individuals, certain trusts, and estates; they may not be partnerships, corporations or non-resident aliens.
- It can have only one class of stock. But, it can have voting and non-voting stock within that single class of stock.
- Certain financial institutions, insurance companies, and domestic international sales corporations are ineligible.
LLC vs the S Corporation
Both of these organizational forms share the characteristic of having "passing-through" income to owner(s). A big difference between an LLC vs an S Corporation is that LLCs do not have the same restrictions on ownership. S Corporations must be owned by individuals (or trusts) that are U.S. citizens or residents, and there must not be more than 100 shareholders. LLCs may be owned by other LLCs or corporations and the owners do not have to be U.S. citizens or residents. There may be an unlimited number of owners in an LLC. Now that you understand the different types, you may be wondering which state should I incorporate in?
Why are Delaware Corporations popular?
- Angel and VC investors tend to prefer to invest in Delaware Corporations
- There is extensive precedent on Delaware Corporate case law
- Corporate case law in Delaware is much more extensive than in other states due to the high volume of corporate cases. With more case law, there is stronger predictability of the likely judicial resolution of a business law dispute.
- There are privacy protections in Delaware Specifically, Delaware does not require officer or director names to be disclosed on formation documents. This provides a layer of anonymity that is not available in some states.
While there are many options and particularities, each entity form has its own advantages and disadvantages to keep in mind. If you are looking for VC Funding, most VC firms will only invest in a C Corporation. However, this does not mean you have to start as a C Corporation. You can convert an S Corporation back to a C Corporation. If you’re looking to build a lifestyle business, an LLC may be your best option with its flexibility and ease of maintenance. If you are looking to file, change or maintain a corporation, Sternberg Legal can review your options with you.
Disclaimer: This article discusses general legal issues, but it does not constitute legal advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.