Now that you have read:
You thoroughly understand what makes up a business entity. Now let’s go a little further in comparing these business entities to find the best one for your business.
What are the primary considerations in carrying on business as a sole proprietorship?
If the entrepreneur is the sole owner of the business activity, the ease of formation and flexibility of the entity make a sole proprietorship a very easy and convenient form of business entity. The major concern for the sole proprietor is personal liability for the debts of the business. There are some situations, however, where forming a business entity with limited liability protection does nothing to protect the individual owner.
• Note: If an entrepreneur provides a service, does not have employees, and does not have a physical space open to clients, then a sole proprietorship may be an appropriate entity form.
• Example: Tom is a freelance consultant who does any work on the contracting employer’s work sight. He strictly provides personal services. He does not sell any products, have a place of business, or employ any employees. In such a case, a sole proprietorship may be appropriate for Tom’s business.
Is a sole proprietorship ever appropriate for a business that sells products?
If the entrepreneur produces or sells a product, then a customer could potentially be harmed (physically or financially) by the product. This could lead to liability for the defective design or manufacture of the product. For this reason, a limited liability entity is generally the best choice for product businesses. In contrast, this is not a concern for a service provider. While a service provider may commit malpractice for a client, a limited liability entity will not protect her. Remember, an individual is always personally liable for her own activity. Forming a limited liability entity would not shield her.
• Example: Winston is a mechanical engineer and designer. He enters a work-for-hire agreement to design and build a machine that will construct a certain type of toy for Toy Company, Inc. Winston is compensated primarily for his design service and also receives compensation when his employee (a machinist) constructs the final product. The product later malfunctions and injures several Toy Company employees. The employees receive worker’s compensation from Toy Company but now wish to sue Winston for product liability. If Winston is a sole proprietor, he will be personally liable for the injuries. A limited liability entity may protect Winston from personal liability if his employee improperly manufactured the product. It may not protect him if his design was defective as he personally designed the product.
• Note: Product liability is a strict liability tort. A plaintiff would not have to show that a manufacturer is negligent in any way. If the good is used in a reasonably foreseeable manner and it harms the user, then the manufacturer or seller of the good can be held liable.
Is a sole proprietorship appropriate for a business that has employees?
The analysis changes if our sole proprietor in the above scenario is an employer. As previously stated, she will be liable for her own malpractice and a limited liability entity will not protect her personal assets. If she has employees, however, a limited liability entity could afford her a layer of protection. As a sole proprietor, any employee of the business acts as her agent. As discussed in chapter 3, these agents could potentially cause her personal liability in contract or tort. A limited liability entity will protect her from personal liability for the actions of agents (employees). The actions of the employees will subject the business entity to liability and not the owner.
• Example: Janice is an attorney who provides estate planning services to clients. She employs Eric as a secretary. Janice and Eric routinely receive lots of personal information about clients, including private health information. Eric learns that a client has a likely fatal disease and he discloses that information to his friends. If the client is adversely affected by the disclosure of this private health information, they may have a cause of action against Eric and Janice’s law firm for disclosing the information (e.g., an invasion of privacy claim). If Janice is a sole proprietor, Eric’s actions could subject her to personal liability.
• Note: If the owner chooses a limited liability entity status to protect herself from personal liability for the act of agent, she will still have to maintain business formalities for the business entity to avoid being disregarded by the court.
Should a business with a physical business location that is open to the public operate as a sole proprietorship?
A business that opens its doors to the public risks personal liability for injuries suffered by customers or clients entering the premises. The business owner has a duty to keep the premises reasonably safe for the public. If she drops below this standard, then she could be held liable for her negligence. A limited liability entity status does not protect the entity from liability, but it will protect the owner from personal liability for the business’ negligence in a case like this.
• Example: Alice has a photography business. She invites individuals into her photo studio to take portraits. Her equipment is all electronic and she runs electrical cords across the floor to power the equipment. A family comes into the studio to take a family portrait, and the mother trips on the cord and injures herself. In a sole proprietorship Alice would be personally liable for negligently failing to warn customers about the cords or failing to secure the cords in a manner to reduce the possibility of injury.
• Note: Common examples of failure to keep the premises safe include slip-and-fall accidents. If the owner knows that the floor is slippery (or should know that the floor is slippery) and fails to warn patrons, then she has fallen below her duty of care. A limited liability entity could create a layer of protection for the owner. A slip-and-fall accident would subject the business entity to liability, but would shield the owner’s personal assets.
Should a business with potential contract liability operate as a sole proprietorship?
Lastly, a sole proprietor is personally liable on any contracts of the business. A contract is any transactional arrangement, whether or not reduced to writing, including any business loans or other payment obligations. It also includes any loans, contracts, or other obligations that are in the business’s name. Even if the business provides services and does not have a place of business, or employees, then it still may be advantageous to adopt a limited liability entity form. The limited liability entity status will shield the business owner’s personal assets from attachment by creditors in the event of contractual loss (such as a breach of contract).
• Example: Gary is a sole proprietor. As part of his business, he enters into multiple contracts with suppliers and distributors. If Gary’s business is unable to perform its contract obligations or otherwise breaches these contracts, Gary will be personally liable for any damages arising pursuant to the breach.
• Note: Choosing a limited liability form to shield the sole proprietor from personal liability on contracts may not advance the interests of the business. In reality it is unlikely any lender will lend to this type of limited liability entity and not require a personal guarantee from the owner. Larger, more established businesses have assets sufficient to securitize business debts. Smaller businesses often lack these assets. Lenders will not take the risk of loss associated with lending to these businesses without a personal guarantee by the owner.
What are the primary considerations for the GP?
When multiple individuals establish a business venture, a GP offers numerous advantages. The GP form allows for flexibility in operations and governance. The parties can allocate ownership, profits and losses, and authority in any way they desire. Further, the GP provides pass-through taxation to the partners. This avoids the double taxation associated with corporate entity forms and may result in a lower tax burden on the employer. The benefits and detriments of the pass-through tax structure are discussed below in the context of the LLC. Taken together, these characteristics make the GP seem a viable entity type for a startup.
• Note: Many of the characteristics of the sole proprietorship apply equally to the GP. The notable distinction of the GP is that it involves two or more persons as partners. Each partner is an agent of the business in the same way that an employee is an agent. This leads to concerns over agency liability for the partners.
A GP, however, is perhaps the most risky form of business entity. As with the sole proprietorship, the partner is personally liable for all debts and torts of the business. The GP magnifies this risk, as each partner is also personally liable for the tortious actions of each partner. Recall the discussion from Chapter 3 on tort liability for the agents of the business. Each partner is also an agent of the business for purposes of contracting and has authority to carry out any acts on behalf of the GP because of these risks. A GP should only be considered when a limited liability entity would not provide protection to the parties.
• Note: A GP between a marital couple in a community property state may be appropriate if: it is a service partnership, does not have a business location open to the public, and there are no other employees. The reason is because the jointly held or owned assets of the couple may already be at risk by the actions of either spouse. As such, an alternative entity form will not protect those assets.
What are the primary considerations for the LP?
If the sole proprietor from the earlier example needs investment capital for her business, a LP may be appropriate. LPs have all of the flexibility in entity governance and maintenance associated with a GP, but also provide limited liability to its limited partners. The limited partner has no liability for business debts or liability above her capital investment. That is, she cannot lose more money that she has invested in the business. This status is similar within any limited liability entity. The general partner(s), on the other hand, have no personal liability protection. They will still be liable as general partners for any debts or liabilities of the business.
• Note: LPs are generally not used in startup ventures. The LP form exposes the general partner to a great deal of personal liability for the business activities. LPs are primarily used in specialty industries where one or more limited liability entities serve as the general partner(s). Most venture capital and private equity funds are organized as LPs.
What are the considerations for a LLP?
LLPs are a valid form of entity for professional service providers. In fact, most state laws restrict these entities to these types of organizations. The benefit of this type of entity is that it allows for the flexibility of a GP and for the limited personal liability of the partners.
• Note: State law sometimes limits liability protection by protecting partners from liability for tortious activity of other partners or employees but making partners personally liable for the contractual debts of the business.
LIMITED LIABILITY COMPANIES
What are the primary considerations for the LLC?
A LLC is likely the most popular and fastest growing entity choice for small businesses in the United States. For startup businesses, the LLC combines the favorable attributes of a GP with those of the corporation. Notably, the LLC entity form can have any number of members, it offers a high level of flexibility in management and governance, and provides pass-through taxation to the members. Perhaps most importantly, it provides limited liability to the managers. These attributes are the reason that the LLC is such a popular entity form.
• Note: As a newer entity form, state law has not fully developed around the LLC. Many states have adopted model LLC acts to provide an additional level of certainty in the law surrounding the LLC.
How does the LLC management structure provide benefits for a startup?
A key benefit to the startup LLC is the ability to customize the management structure. Recall that the LLC offers two types of management organization, member-managed and manager-managed. The member-managed LLC is very similar to a GP in that each member has the authority to act on behalf of the business. This entity form allows the LLC to avoid withholding payroll taxes (a significant administrative burden), as the members often pay self-employment taxes on their distributions. If, however, any of the members do not wish to take part in daily affairs of the business or wish to hire professional managers, the LLC allows for this as well. In such a situation, the non-managing members will act more like the shareholders and board of directors in a corporation. They will vote and collaborate on major decisions, but the daily operation of the LLC is left to the managers. Combine this flexibility in structure with limited liability protection for each member, and the LLC is a superior form of entity for many small businesses.
• Note: Generally, an LLC will withhold payroll taxes on salaried employees of the business. If, however, members are selected as managers to run the business and receive a salary, this salary will be treated as a guaranteed payment to the member. The LLC will not withhold payroll taxes from the member’s payment; rather, the employee will report the guaranteed salary as self-employment income.
What are the primary drawbacks to using an LLC as a startup structure?
The primary drawback to an LLC as a startup structure is the lack of formalized procedures for selling an ownership interest to outside investors. Corporations have a developed entity structure and a well-defined body of law surrounding shareholder rights. LLCs are a much newer form of entity and, by default, have only one class of equity ownership — the membership unit. Many state statutes, however, allow for multiple classes of membership unit, as investors generally desire a preferred class of security. If the LLC wants to create classes of voting member with rights and authority similar to that of common and preferred shareholders in a corporation, it has to do so through a combination of provisions in the operating agreement and contractual agreements among the members. Drafting these contracts can be more complex and expensive than in a corporation, as LLC law is less developed in many states and may require greater effort by the legal practitioners. Further, each time there is a change in membership or growth in the business, these contracts may need to be updated. If the LLC needs this level of structural sophistication, the cost and difficulty of creation and maintenance may far exceed that of a corporate entity form. Further, equity investors are often reluctant to invest in LLCs. The lack of certainty in the entity form, a lack of understanding of the multiple classes of ownership interest, and the burden of maintenance dissuade investors from investing in the entity.
• Note: Adopting the LLC to meet the growth needs of a startup venture is often difficult. To mimic the provisions of preferred shares in a corporation, the LLC may be forced to issue contractually restricted membership units that vest over a period of time. The LLC will have to create special agreements for granting options to employees. The LLC does not have authorized shares, so any new distribution of equity requires the authorization of new membership units. Outside investors often want preferred status with regard to distributions, voting rights, liquidation preferences, etc. Arranging for all of these special arrangements in an LLC is difficult and is very likely to produce conflicts among owners.
When is a LLC tax structure advantageous for startups?
LLCs are generally only appropriate for startup ventures when the founders use the entity to take advantage of the pass-through taxation features. Benefits associated with pass-through taxation that are common to partnerships and LLCs are as follows:
• Pass-Through Taxation – Profits are easily withdrawn from the business entity without additional tax consequences.
• Special Allocations – Investors may designate special allocations of LLC profits and losses in a given year that do not correspond exactly with the ownership structure.
• Passive Income – Profit may be designated as passive income in certain scenarios.
• Basis Adjustment – The ability to adjust an owner’s basis (outside basis) in the entity can give rise to certain tax benefits.
• Inside Basis – The internal basis (inside basis) in property contributed to the entity can give rise to certain tax benefits.
• Profits Interest – The LLC allows members to receive a profits-only interest stake in the venture that avoids some of the tax implications of purchasing equity in the venture. Such flexibility is not available in a corporate form.
What are the tax disadvantages for a startup to file as an LLC?
While the LLC offers pass-through taxation to owners, there are numerous tax disadvantages. Many of the specialty provisions that an LLC may introduce do not receive the tax advantages that corporate securities receive. For example, LLC shares may not qualify for the benefits associated with Qualified Small Business Stock under IRC Section 1045. The primary tax concerns of the LLC as a startup entity are as follows:
• Active Income – LLC income or losses may be treated as “active” income.
• Self-Employment Taxes – LLC members’ income allocation may be subject to self-employment tax.
• Phantom Income – LLC profits or sweat-equity arrangements can give rise to phantom income, as discussed in Chapters 4 & 6.
• Ordinary Income Property – A member who contributes assets to the business that are considered “Ordinary Income Assets” (see IRC Section 751) can give rise to ordinary income for the contributing member.
What are the primary considerations for startups considering a corporate entity status?
Corporations provide numerous advantages to a startup business. A benefit is the ability to customize the management structure to meet the needs of the entrepreneur(s) and the outside investors. The corporation offers the greatest degree of personal liability protection for owners in their roles as shareholder, director, or officer. It also allows flexibility in providing employees with equity incentives, such as vesting plans and option plans. There is also a litany of tax-associated benefits both for C and S corporations.
What about the C corporation maintenance requirements?
The corporate entity form provides a comprehensive business structure, limited liability for employees, and the ability to sell and distribute shares to equity investors. There are two primary concerns when selecting C corporation status: entity governance requirements and the double taxation of business profits. In general, the corporate form requires far more formal maintenance procedures than other entity forms.
What are the benefits and detriments of the double tax structure?
The double taxation structure will often lead to higher tax liability for owners of the corporation than in a pass-through taxation entity. There are scenarios, however, where the double taxation of corporate profits will yield a lower total tax burden on owners. This is possible because of the ever-changing taxation rates and the responsibility of individuals to pay self-employment taxes on certain pass-through income.
• Note: The individual and corporate taxes rate changes from year to year. In any given year a combination of the corporate tax rate and the individual dividend rate may be lower than the taxpayer’s individual income tax rate. This is particularly true when you include responsibility for payroll or self-employment taxes, which are not included in dividend payments.
• Example: Derek is the sole owner of a C corporation. The corporation earns profits of $10,000 in a year. The corporation will pay taxes on the income at its corporate tax rate. We will use 25% for purposes of this example. This leave $7,500 in profit. Now, when this $7,500 is distributed to Derek, he will pay taxes on the dividend at the applicable dividend rate. We will use 20% for purposes of this example. After taxes, Derek will receive $6,000 of the after-tax profits of the corporation. If the business were a pass-through entity, such as an LLC, Eric may be subject to self-employment taxes on the profits, as well as personal income taxes. If his personal income tax rate is 36%, and his total self-employment tax liability is 15.8%, then he would receive $5,820 in after-tax profits of the LLC.
One advantage to the double taxation regime is the ability to retain profits (and in some cases losses) at the corporate level. As is the case in startups, if the investors wish to reinvest profits, the C corporation avoids the issue of “phantom income”. As previously discussed, phantom income arise when a business owner is taxed on her share of business profits when there is no distribution. The disadvantage of this scenario is that business losses are not passed through to shareholders; rather, the corporation retains these loses. These losses are generally available to offset income from the past 2 years and for the next 20 years. In the event of a merger or sale of the corporation, these losses can be valuable to the acquiring entity.
• Example: Tom owns a C corporation. It makes a profit at the end of the year of $30,000. The corporation will have to pay income taxes on that $30,000 at the applicable corporate tax rate. If the business does not distribute any of the profits to Tom, then he does not pay taxes on those funds. If the business were organized as a LLC or S corporation, then Tom would have to pay taxes on the profits attributable to him as owner. In other words, the C corporation entity form avoids the “phantom income” situation.
• Note: Accumulated losses are not lost in a startup that seeks to benefit investors and owners at the time of business exit. Any losses retained by the corporation at the time of an exit event (e.g., sale of the business) can be used to offset any capital gains taxes incurred by the owners/investors at the time of sale. Congress has also enacted special rules to benefit small business owners operating in the corporate form.
What other tax benefits exist for the C corporation?
A detailed description of the tax benefits associated with any business entity are beyond the scope of this text; however, it is important that you have a general understanding of the primary tax benefits available for startup ventures. Below is a list and short description of many of the tax-associated, C corporation benefits for further research.
• Shareholder and Employee Benefits – The corporation can provide to shareholders and employees certain health, welfare and retirement benefits that are tax deductible to the corporation.
• Fiscal Year Election – The corporation has greater flexibility in designating a fiscal year other than the calendar year.
• Long-Term Capital Gain Rates – Gains on the sale of stock of a C corporation held by a shareholder for more than one year are taxed at a 15% tax rate. This is often far lower than the tax rate for individual income.
• Ordinary Loss Treatment – IRC Section 1244 allows the shareholder of a qualifying C corporation to treat any losses on the sale of the corporation’s stock as an ordinary loss up to $50K for individuals or $100K for married couples per year. This means that the losses can offset ordinary income. Generally, such losses are treated as capital losses and can only be used to offset capital gains. To qualify, the C corporation cannot have a market capitalization (contributions and retained earnings) greater than $1 million, and the shareholder must be the original purchaser of the loss-producing shares sold. This means that shares awarded for services rendered to the corporation are not eligible for the ordinary loss treatment.
• Qualified Small Business Stock Benefits
⁃ IRC Section 1045 allows individual shareholders to defer the recognition of any gain on the sale of qualified small business stock (QSBS). The requirements to qualify as QSBS are extensive. The corporation must have less than $50M in gross assets at the time of issuance; the issuance must take place after Aug 10, 1993; the shares must be acquired by the original issuee; and the shares must held by a non-corporate taxpayer. For a transaction to qualify, the shareholder must have held the stock for longer than six months. Further, the proceeds from sale must be reinvested in another qualified small business within 60 days of the date of sale. Deferring the recognition of any gain on sale can be very attractive for startup owners.
⁃ IRC Section 1202 allows shareholders to exclude from income up to 100% of the gain on the sale of the QSBS up to $10 million or ten times the shareholder’s basis in the stock, whichever is greater. There are, however, significant limits on this provision. This provision applies to QSBS issued directly to C corporation shareholders after Aug. 10, 1993. The exclusion is not available to shareholders who are not the original issuee and the C corporation cannot have more than $50 million in assets at the time the stock is issued. The downside to this provision is that any percentage of the gain that is recognized is taxable at a flat 28%, which is well higher than the current 15% long-term capital gain rate.
What other tax detriments exist for the C corporation?
The primary tax detriment for C corporations, discussed at length throughout this text, is the double taxation structure. Much time is spent in corporate tax planning to avoid the negative consequences that exist in this structure. Below are a few of the major tax detriments associated with the C corporation:
• Corporate Losses – The shareholder of a corporation cannot use or otherwise take advantage of corporate losses. In an S corporation, the entity losses flow through to the taxpayer. This is not the case in the C corporation. Losses are trapped at the entity level and can generally be used to offset profit in the previous 2 years or in the following 20 years.
• Fixed Corporate Basis – Startups organized as C corporations often distribute stock to shareholders in exchange for value to the corporation. The value of services, cash, guarantees of debt, or property provided to the corporation in exchange for the stock is the shareholder’s basis in that stock. The shareholder’s basis in that stock remains fixed and does not vary with the performance of the corporation, as is the case with other entities. The ability to adjust one’s basis can be a significant advantage for the shareholder, but this action is not available in the C corporation without additional contribution of capital.
• Capital Gain Rates – Capital gains on the sale of property held by a C corporation are taxed at the corporation’s ordinary income tax rate. In a flow-through entity, however, owners enjoy a lower personal capital gain rate on the sale of property by the entity.
• Redemption of Stock for Cash – If a C corporation redeems (repurchases) the stock of a shareholder, then the entire purchase price is treated as a dividend to the shareholder to the extent of the corporations earnings and profits. Currently, dividend and capital gain rates are equal. The issue, however, is that the shareholder’s basis is not recovered prior to treating the distribution as a dividend. The shareholder may be forced to claim a capital loss on the transfer of the stock back to the corporation. There is, however, an exemption to this rule under IRC Section 302(b). This provision allows the shareholder to treat the redemption as a sale of the shares to the corporation if certain requirements are met. As such, upon redemption, the shareholder recovers her basis in the shares before incurring a tax liability for the gains or losses incurred. When considering redemption of C corporation stock, consult a professional to plan for a redemption scenario with the lowest possible tax repercussions.
• Redemption of Stock for Property – The above scenario demonstrates a negative tax consequence when a corporation redeems the equity of a shareholder for cash. Another issue arises when the corporation redeems those shares for property in the corporation. If the property has a built-in gain then the distribution will cause a gain tax to the corporation and a dividend to the shareholder for the fair market value of the property. As is the case above, the corporation can avoid this tax consequence if an IRC Section 302(b) exception applies.
• Excess Accumulated Earnings – IRC Section 531 allows for a tax penalty on C corporations that retain excessive earnings, rather than distributing those earnings to shareholders. A corporation must show a reasonable business need for retaining such earnings to avoid a 20% corporate tax penalty on those earnings. This situation is generally not a concern for startups, as most startups readily employ their earnings in growing the business and have a reasonable business need for retaining earnings.
• Alternative Minimum Tax (AMT) – Corporations are subject to the AMT. This is a complicated calculation that makes certain that corporation pay income tax on a minimum percentage of attributed income in a given year. It seeks to avoid the effects of excessive deductions, credits, and other tax deferral arrangements on the corporation’s income tax liability in a given year. There are numerous exemptions for new corporation with less than $5M in gross receipts within the first 5 years of operations and less than $7.5M in gross receipts in any 3 years of operations. The AMT is normally not a threat for startup ventures that often incur extensive losses during the development stages.
How does the C corporation equity structure benefit the startup?
Lastly, and probably the greatest advantage for entrepreneurs, the C corporation allows for the authorization and distribution of multiple classes of stock. While founders of a corporation receive common stock, equity investors generally require preferred stock interests. Preferred equity provides the investors with various levels of protection from loss, such as a dividend preference, liquidation preference, participation rights, redemption rights, etc.
• Note: The preferences generally regard the right to recover one’s invested capital before any other equity owners receive any proceeds of an exit (known as a “liquidation preference”). The details of preferred stock and terms of investment are complicated subjects that exceed the scope of this text.
What about the S corporation?
An S corporation provides the organizational structure of a corporation and pass-through taxation similar to that of a partnership (with several notable differences). The difficulty for many startups in choosing S corporation entity status is that the business activity must meet numerous requirements in order to qualify for the election. Recall, there can be no more than 100 investors, each must be an individual, an American citizen (or resident alien), and there can only be one class of equity ownership. All of these factors are of primary concern to growth-based startups.
• Note: Remember that the startup venture is growth-based. It depends upon outside capital from investors to achieve its growth targets. Many outside investors, such as venture capital firms, are businesses. An S corp does not allow these business entities to own an equity interest in the business. Further, outside investors generally purchase a preferred class of business ownership. The S corp does not allow for the designation of a preferred or special class of ownership. Each of these issues is discussed below.
What tax benefits exist for the S corporation?
The primary benefit of an S corporation is pass-through taxation. That is, the business entity does not pay taxes; rather, the income or losses of the business activity pass through the business entity and are reported on the income tax returns of the individual owners. In this regard, the S corporation enjoys the structural characteristics of a C corporation with a tax structure very similar to that of partnership and LLCs. Other beneficial income tax characteristics of the S corporation are as follows:
• Passive Income – Owners of an S corporation treat business profits as passive income. Owners working in the S corporation must receive a salary for services rendered to the business. This salary is subject to payroll taxes for the employer and employee. Passive income for shareholders who are not “material participants” in the organization is subject to ordinary income tax rates, but is not subject to payroll taxes by the business or the employee.
• Basis Adjustments – Like a partnership-taxed entity, the S corporation shareholder’s basis is adjusted up or down by earnings and distributions of the business. The individual shareholder pays income taxes on her share of the S corporation profit. If the S corporation retains (does not distribute) any profits, the shareholders’ basis in the business increase by this amount.
What tax detriments exist for the S corporation?
The primary tax detriment of the S corporation is the counter to the advantages of the S corporation tax structure. That is, losses that pass through the S corporation to shareholders who do not “materially participate” in S corporation activities are passive losses. Passive losses can only be used to offset passive income. Another common tax detriment is the inability to make special allocations in the S corporation. That is, shareholders receive a percentage of business profits and losses based upon their respective ownership interests in the entity. In contrast, partnership-taxed entities are able to make special allocations to shareholders and C corporations are able to issue preferred stock that may alter the distribution of business profits or losses.
How does the S corporation compare to the LLC as a startup entity?
The 100 investor limitation is not a primary area of concern between an LLC and S corporation, as most startups do not achieve this mark before going through extensive equity offerings. Both entities provide similar flow-through structures for taxation. If the startup requires adherence to the corporate entity structure (shareholders, directors, and officers) then the S corporation avoids the burdens of establishing these roles through contractual arrangement.
The first major drawback of the S corporation is the limitation to one class of equity security. The S corporation, unlike the LLC, does not allow for profit-only interest stakes in the venture. This type of interest may be considered a security and disqualify the entity from S corporation status.
• Example: Alfred is an angel investor. He identifies Morgan’s startup as a promising venture. Morgan is currently organized as an S corporation. Alfred is not interested in common stock in the S corporation. He wants to make certain that when the business is sold in the future that he will receive a return on his investment before Morgan or anyone else receives any of the proceeds. As such, he asks that Morgan convert the entity into a C corporation. She can then authorize a second class of preferred stock that has a liquidation preference. When Alfred invests in the business, he will receive preferred stock in exchange for his invested capital.
• Note: Recall, preferred shares allow a special allocation of interest (dividend, liquidation preference, decision rights, etc.) that are not available to the common stock holder. S corporations and LLCs cannot issue preferred stock, but the LLC can issue alternative interests that are not available to the S corporation. The profit-only interest is a common LLC right given to outside investors who seek special rights.
A second drawback is that the S corporation does not allow for special allocations of profits and losses. Each shareholder must share in the income in direct proportion to their ownership interest.
• Example: Bob, Kate, and Julie form an S corporation for their business and each hold the same number of shares in the business. Bob works in the business part-time, Kate works full time and Julie is just a silent investor. Bob and Kate will receive a salary for their work in the business. After that, all profits of the corporation are distributed equally to the owners. All three shareholders realize that the business is successful based largely on the efforts of Bob. They determine that Bob should receive more of the business profits that Kate and Julie. They are disappointed to learn that they cannot make a special allocation of profits to Bob that is different from his ownership percentage. If they were an LLC, then they could make this special allocation. They decide to pay Bob an additional bonus as part of his salary rather than an additional allocation of business profits.
• Note: Most startup investors do not wish to receive a distribution from the business activity. The money is better reinvested to grow the business. These businesses will, however, seek to use an allocation of losses to offset other income. The ability to specifically allocate income or loss could be an important draw to an outside investor.
A third important distinction between the LLC and S corporation is how business profits are taxed to the owners. In an LLC the members pay ordinary income taxes (possibly including self-employment taxes) on their distributions received from LLC profits. This result is largely the same whether the LLC is member-managed or manager-managed. In an S corporation, employee-shareholders receive a salary for their services to the business. They also receive a distribution of business profits based upon their percentage of ownership. These employees pay ordinary income and self-employment taxes on their salary. They also pay ordinary income taxes on their distributive share of profits. While employee shareholders pay self-employment taxes on their salaries, S corporations shareholders who are passive investors do not pay self-employment taxes on their distributive share.
• Example: In the above example, Bob receives both salary and a distribution of profits from the S corporation. His salary will be subject to payroll taxes. He will pay a portion of those taxes and the business will pay the other portion. His share of S corporation profits, however, is treated as passive income. He will be subject to income tax on his share of income but will not have to pay self-employment taxes on that amount.
• Note: The fact that passive investors in the S corporation (or any corporation for that matter) do not pay self-employment taxes on their share of income is a huge advantage to those investors (such as angel investors and venture capitalists). This fact alone leads many investors to prefer the S corporation status over the LLC. The IRS has considered aligning the taxation of distributions to members of a member-managed LLC with those of passive investors in an S corporation. The recommendations were made more than a decade ago, but Congress has not yet acted on the recommendations.
Another disadvantage is that funds guaranteed on behalf of the S corp are not part of the basis or at-risk amount of shareholders. This means that personally guaranteeing a business loan does not provide the tax advantages available to the partnership or LLC. If a business expects to incur extensive losses in a given year, then investors may seek to use these losses to offset their other income. Rather than invest all of the money employed by the business, many investors/owners will personally guarantee third-party loans to the business. In a partnership (and LLC) these loans raise the investor’s basis in the business, so that sustained losses can be used in excess of the actual capital invested. An S corp does not allow an increase in basis for personally guaranteed loans. As such, some of the losses incurred in the business may not be useable by the investors due to basis limitations. Lending money directly to the corporation, however, will help the shareholder in using the losses by increasing her “debt basis”.
• Note: The inability to increase one’s basis by personally guaranteeing loans is not a large concern for outside investors. Angel and institutional investors do not frequently guarantee loans; rather, they infuse cash whenever needed.
Lastly, and perhaps the most important limitation for startups in choosing an S corporation entity status, is the requirement that all members be individuals (not businesses). Venture capital firms are organized as LPs, with an LLC or corporation serving as general partner in the relationship. The LP will invest funds by purchasing equity in the business entity. This arrangement effectively prohibits venture capital investment in businesses organized as S corporations.
• Note: This may not be an issue for early stage startups who seek angel investment. Angel investors are high-net-worth individuals who invest (much in the same way as venture capital firms) in startup ventures. These individuals may be willing to invest in S corporations, and they do not run afoul of the individual investor requirement.
What about a non-profit entity?
A startup generally cannot operate as a non-profit due to the inability to have owners (investors). While some businesses organize and grow large in non-profit status, it is generally in select industries, such as medicine and literary publications.
• Note: Non-profits do not allow earnings to inure to owners. The only funds available to members of a non-profit are salaries paid for services rendered. While such salaries may be very lucrative, there are certain IRS limitations on the amount an employee of a non-profit is allowed to receive as compensation.