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Business Formation

Choice of Entity for Business Startups

There are many different entity formation options available for small business clients to choose from. Our lawyers guide our clients through each option to best fit their needs based upon the goals of the entrepreneurs, the owners’ tax situations, and the exit strategy. We help our clients understand the difference between entity requirements for state law issues as well as their options for Federal taxation to meet both short and long term goals. We have helped entrepreneur start-ups with the following entities:

    • LLC (Limited Liability Company)
    • Corporations
    • Small Business Corporation (S-Corporation)
    • Professional Limited Liability Company

Our services range from helping new clients through the initial start-up procedure, through capitalization and on-going business transactions, all the way through wind up and dissolution of a business.

Generally, the first consideration in setting up a business is the choice of entity in which to conduct the business. To that end, there are tax and nontax considerations. This item presents an overview of some of the tax points that should be kept in mind when choosing an entity. It focuses primarily on the taxation of the partnership and corporate forms of doing business, the pros and cons of each, as well as the distinctions between C corporations and S corporations.

To set the stage, the item sets forth some nontax considerations for partnerships, corporations, and limited liability companies (LLCs). For tax purposes, an LLC may afford more flexibility because, through a simple election, it can be taxed either as a partnership, a C corporation, or an S corporation. Next, this item focuses on tax considerations, contrasting the income taxation of partnerships, C corporations, and S corporations, and exploring issues such as compensatory options and attracting investors. Finally, this item examines a few critical post-formation considerations, focusing on the implications of foreign operations and certain issues related to separating business lines.

Partnership: A partnership is a legal entity for a business entered into by two or more persons. There are two types of partnerships: general or limited. In a general partnership, all the partners are personally liable for partnership debts. In a limited partnership, however, at least one partner must be designated as the general partner, and that general partner has unlimited personal liability for partnership debts. The limited partners, on the other hand, are liable only to the extent of their investment in the company. However, a limited partner might lose his or her "limited" status and thus be personally liable for partnership debts if he or she is viewed as playing a role in management, i.e., acting as something other than a purely passive investor.

Corporation: Corporations are legal entities independent from their owners and provide some protection from personal liability. Thus, a shareholder's risk of loss is limited to his or her direct investment in the corporation. However, to sustain that liability shield, certain legal formalities must be observed, e.g., a corporate charter, bylaws, and a board of directors, as well as compliance with regulatory reporting requirements. Compliance with these formalities often comes with significant legal costs, which may be daunting for a startup company.

Additionally, shareholder and stock restrictions under Sec. 1361 come into play when comparing an S corporation to a C corporation. C corporations allow for an unlimited number of shareholders, with no restrictions on the type of ownership, whereas S corporations have a limit of 100 shareholders, all of which must be either U.S. citizens or permanent residents, certain trusts, bankruptcy estates, other estates, and certain tax-exempt organizations, not corporations (including LLCs) or partnerships. Although a C corporation does not restrict stock issuance, an S corporation can have only one class of stock.

LLC: LLCs have become increasingly common, particularly in the startup realm. In general, it is far easier and less expensive to set up an LLC than it is to set up a corporation. An LLC only requires an operating agreement outlining the expected duties of managers and the general governance of the company, thereby avoiding some of the costlier corporate formalities mentioned above.

 

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