When you make that final decision to plunge ahead and start your own business, you need to consider the legal form that it will take. All companies operate under one of four broad legal classifications:
Sole proprietorship
Partnership
Corporation
Limited Liability Company (LLC)
Many entrepreneurs assume that the best entity is always one that lets profits pass through to the owners at their personal tax rate. They further assume that incorporating in your home state is always best. These assumptions can be wrong for some entrepreneurs and for some businesses.
For example, if you know that you want to do an IPO (initial public offering) within two years, you should probably form as a C Corporation, because that form is required to go public. If you’re going to use venture capital, you probably also want a C corporate form, and you may want to incorporate in California or Delaware.
Why? Those states have a substantial body of law in the area of corporate governance. Choosing the wrong entity when speed is of the essence (consider the case of Internet startups) can mean costly delays and lost opportunities.
Understanding the various factors that come into play when you choose a particular form of legal structure is important. Seven factors affect your choice of structure.
Here the factors are presented in the form of questions you can ask yourself:
Who will be the owners of the company?
If more than one individual owns the company, you can eliminate sole proprietorship as an option. If many people own the company, the C Corporation form is often the choice because it has an unlimited life and free transferability of interests. If you intend to have many employees, the C Corporation also lets you take advantage of pension plans and stock option plans.
What level of liability protection do you require, especially for your personal assets?
Some forms protect you; others do not. It’s a sad fact that too many businesses ignore the risks they face and don’t acquire the correct forms of insurance. Just as you want to seek the advice of an attorney and accountant as you develop your business, you also want to consider the advice of an insurance broker.
How do you expect to distribute the company’s earnings?
If you choose an entity allowing pass‐through income and losses (partnership, S Corporation, or LLC), tax items at the entity level are allocated immediately without additional taxation, although cash may or may not be distributed. But in a C Corporation, only a salary or other forms of compensation are paid out pretax from the company to an owner.
What are the operating requirements of your business and the costs of running the business under the particular form in question?
If you own a manufacturing company that uses a lot of machinery, you have different liabilities than a service company.
What are your financing plans?
How attractive is the form to potential investors? Are you able to offer ownership interests to investors and employees? In general, if you’re going to use venture capital, you need a corporate form. Most venture capitalists raise their money from tax‐exempt entities such as pension funds, universities, and charitable organizations. These organizations can’t invest in companies that have pass‐through tax benefits.
What will be the effect on the company’s tax strategy and your personal tax strategy?
This includes everything from minimizing tax liability, converting ordinary income to capital gain, and avoiding multiple taxation to maximizing the benefits of startup losses.
Do you expect the company to generate a profit or loss in the beginning?
If you think your company will lose money for the first few years (this is often true with biotech or other companies developing new products), then a pass‐through option can be justified because you get to deduct your losses on your personal tax return.