Use this as a guide through the entity choice, creation, structuring, and funding process. More specifically, it will walk you through the considerations and steps to selecting and forming a business entity and then setting that entity up to carry on business. It introduces you to the primary characteristics of business entities, the types of business entities, and the characteristics for those entities. It then explains the steps required to form the entity and structure ownership interests. Everything trees down for an expanded explanation of concepts. Key concepts are linked to our deeper explanations in separate articles
What are my primary Business Entity Considerations?
Let’s begin by learning the primary Characteristics of a Business Entity that may fit a particular business venture. The primary characteristics include: Formation (Creation), Continuity, Maintenance (Governance), Ownership Structure, Control, Personal (Owner) Liability, Compensation, and Taxation (discussed below). Click through each of these if you want to dig in. Understanding each of these attributes is essential to choosing the appropriate entity. Plainly stated, you must have a thorough understanding of what you expect of your business venture and how you expect it to evolve. For example, our lecture on Startups vs Small Businesses discusses the disparate business objectives of a small business and a startup venture. Further, you may change business entity types as the business evolves. For example, outside investors generally want a business entity to be a C – Corporation (see S Corporation for Startup Ventures to understand why). So, you need to understand when the characteristics of another entity form may it advantageous or necessary to modify the entity or choose a new entity type.
What are the Tax Concepts Relevant to Business Entities?
Perhaps the most daunting aspect of a business entity to understand is taxation. Much of business planning concerns tax liability and the objective to pay as little taxes as possible. As such, understanding the types of tax is essential to understand how to organize a business entity to maximize tax benefits for owners. Taxes matter at each stage of the business lifecycle, including when forming, funding, contributing assets to, converting, or exiting the business entity. Later, we will explore the major tax considerations when forming an entity, but first you need to explore the following concepts: Personal vs Business Rates, Active vs Passive Income, Tax Basis in Business
What are the Characteristics of Each Type of Business Entity?
Once you understand the primary characteristics of business entities, the next step is to understand the various business entity options (and their respective attributes). The primary types of business entity are the Sole Proprietorship, General Partnership, Limited Partnership, Limited Liability Partnership, Limited Liability Limited Partnership, Limited Liability Company, and the Corporation. Each of these business entities has various characteristics that may make it the most suitable entity for your business activity at this point in the lifecycle. Most businesses begin as sole proprietorships or partnerships. Once the owners are ready to add additional structure or obtain limited personal liability for entity debts, they convert or reorganize as an LLC or corporation. Business ventures seeking investment from third-party investors often convert to a C – Corporation to more easily allow for multiple types or classes of ownership interest (discussed below).
What are the Special Taxation Considerations of Business Entities?
Like we said, taxation is perhaps the most complicated aspect of business entity selection. In a nutshell, Partnerships and Limited Liability Companies are generally Taxed as Partnerships. Business owners (for strategic reasons – such as avoiding FICA taxes) may choose for the entity to be taxed as a corporation. Corporations are generally Taxed as an S-Corporation or as a C-Corporation. An S-Corporation offers numerous advantages and disadvantages, such as single-level or flow-through taxation; but the business must meet the Requirements for an S-Corporation. Unfortunately, the S-Corporation will not work with the strategic objectives of some business, such as growth-based, startup ventures. A C-Corporation offers many advantages and disadvantages as a business entity, such as the ability to have multiple classes of ownership interest. Notably, the C-Corporation offers significant tax advantages when the equity meets the requirements of “Qualified Small Business Stock” and is later sold.
Where Should I Organize the Business Entity?
Once you have chosen the appropriate business entity form, you will need to decide where to organize the business. This may seem obvious (just form in the state where you live and will do business), but there are a number of primary considerations as to Where to Form a Business. Often businesses will organize their business entity in a state where they do not primarily do business. That is, these businesses organize in one state and have its headquarters in another state. Forming a Corporation in Delaware, for example, is a very popular; while, Nevada has become a popular location for forming an LLC. This is generally for some strategic reason related to applicable laws or investor demand. Two other considerations include 1) costs, such as Franchise Taxes, and 2) registering in a state to do business subjects a business to the court’s jurisdiction (see Personal Jurisdiction) in that state, as this is the necessary “minimum contacts” for jurisdiction. That is, the business can be sued in that state. In some instances, a business will Conduct Business in Multiple States, which adds additional requirements (such as Registering as a Foreign Entity) and operational considerations.
What are the Steps to Form and Organize the Entity Structure?
So, you have chosen your entity. Now, you need to understand how to go about forming and organizing it. Forming a business may occur by default (sole proprietorships or general partnerships) or through the filing of specific documents with the state government (all other types of business entity). In any event, once formed, owners of businesses develop specific forms of operational agreements and ownership agreements to control or guide operations, governance, and ownership structure of the business.
Form a Partnership
Like we said, individuals often begin their business before forming an actual business entity. What they don’t realize, their initial activity actually results in the formation of a general partnership. Stated more technically, two or more individuals may Form a General Partnership by: 1) carrying on a business activity (a default partnership), or 2) by an agreement between the owners to form a general partnership. A default partnership (one without a formal agreement) is generally an At-Will General Partnership, which arises when there is no set date or time period for the partnership. This is in contrast to a term partnership that ends at the conclusion of the partnership’s purpose. In any event, there is no requirement to file with the state government to form a general partnership.
- Note: Forming a Limited Partnership or Forming a Limited Liability Partnership, on the other hand, requires filing with the state’s secretary of state’s office. The reasoning is that public filing puts the public on notice that some of the partners may not be liable for the debts of the business and may not have authority to act on behalf of the business.
Partnership entities, like other business entities, are subjects of state law. The state law will govern the structure operations and control of the business entity, unless the partners to enter into a Partnership Agreement to control these matters. Notably, the partnership agreement should contain rules for operations and ownership interests, such what happens or the process for when a partner leaves the partnership (known as a Buy-Sell Agreement or Provision. As such, we strongly recommend that individuals planning on undertaking a business venture enter into a “Founder’s Agreement”, which is a fancy name for an early partnership agreement.
Form a Limited Liability Company
So, let’s form and structure an LLC to fit your venture. To Form a Limited Liability Company an organizer (representing the future members) must file organization documents and information with the state’s secretary of state’s office. This document names the initial owners. Owners of an LLC are known as “Members”. Once the state issues a certificate of organization, the members should then execute an Operating Agreement to lay out structure, control, and operations issues for the LLC. Ownership interests in an LLC are often designated as “Membership Units” (not stock). The operating agreement should contain a Capitalization Table indicating the ownership interest or units of each LLC member. The LLC agreement may authorize various Types of LLC Ownership Interest, such as “Restricted Units” (similar to classes of stock in a corporation), which will determine the Voting Rights of the members holding these interests. While it is not absolutely necessary, the LLC may enter into a Unit Purchase Agreement with each member when distributing an LLC interest in exchange value provided to the LLC. These agreements will add additional terms or limitations to the ownership interest of members, such as establishing a “Vesting Period” for the ownership interest or “Rights of First Refusal” restricting the re-sale of the ownership interests to third parties without LLC member consent. Another major issue addressed in the LLC or in the unit purchase agreement is what happens when a member leaves the LLC. This is often the subject of a Buy-Sell Agreement or Provision.
Form a Corporation
So, let’s form and structure a Corporation to fit your venture. To begin, a Promoter of a Corporation garners interest from potential future owners (“Shareholders”) of a soon-to-be corporation. Of course, if the business is converting from another entity, such as an LLC, the initial shareholders will likely be prior owners together with any new investors in the entity. In any event, as the next step, an Incorporator takes action to Incorporate or Form the Corporation by filing the Articles of Incorporation with the state secretary of state’s office. Once the state issues a charter, the incorporator will take Initial Actions of Incorporator to set up the management and operational structure of the company, such as designating him/herself as the sole director, appointing the Corporate Secretary, adopting the organizational documents, and Bylaws. The initial director(s) will then make numerous resolutions through “Unanimous Written Consent”, such as: adopting the actions of the sole incorporator, electing officers, determining whether to register with the IRS as an S Corporation, and authorizing Share Purchase Agreements. The board must also authorize the “Certificate of Corporate Stock” and the executed share purchase agreements, which distribute stock shares in exchange for value provided to the corporation (this process for issuing equity is discussed further below). The bylaws and purchase agreements will address major governance issues, such as Types of Corporate Shares, Voting Rights, Buy-Sell Agreement Provisions, etc. Thereafter, the shareholders will vote either through Initial Shareholder Consents or Meeting to approve the board actions and to Elect a Board of Directors. This elected board will continue setting up the corporate structure such as approving a Stock Incentive Plan to compensate employees with equity. Keep reading and learn a bit more about how to fund the corporation and get set up for business.
Converting from One Business Entity to Another?
As your business venture grows or evolves, it may be appropriate to Convert from a Partnership or LLC to a Corporation. So, you understand the advantages of each entity; but, don’t forget to think about taxes. You also need to be aware of the Tax Consequences when Converting from a Partnership to an LLC, or a Converting from an S Corporation to a C Corporation (and vice versa). Tax considerations will guide your decisions on if, when, and how to convert the business entity.
How do I Use Ownership Interests to Fund the Business?
To run a business, you are going to need funds to get started. There are numerous options or sources to Fund a Business Venture. Exchanging business equity for cash, services, or property, is a primary method of funding at any stage of the business lifecycle. Let’s break it down a little bit.
Getting funds from Founders in Exchange for Equity?
To start a business entity, you are probably going to have to contribute something. Most business founders make a Personal Contribution of funds, assets, or work effort to the business in exchange for an ownership or “equity” interest. A company must affirmatively Distribute an Equity Interest to Founders, which requires numerous considerations on how to Split the Equity Ownership Among Co-Founders. The early split of equity between co-founders can be a touchy subject; but, it is essential. Later, we discuss the physical process for providing units, stock shares, or other equity interests to individuals in exchange for the value they are contributing.
- Note: One important consideration is avoiding “Phantom Income”, which subjects a founder to income taxation for the business interest they receive in exchange for services contributed to the business entity.
This initial distribution of equity is subject to change as a business entity grows or develops. It is common to reorganize the ownership structure to accommodate distributions of equity to third-party investors and new employees. Let’s discuss each of these options.
Can I get Funds from Non-Founders?
Once founders have contributed their initial value for equity, other sources of equity funds might come from: Friends, Family, and Fools, or professional Equity Investors. Professional, early-stage equity investment is known as Angel & VC Investment. Angel Investment is investment by high net worth individuals either individually or in groups. They do not work in the business as founders, but they want to hold an interest in the business that they believe will grow rapidly over time. Venture Capital investment, which is also a broad term that often includes angel investment and other types of equity investment, is an equity investment by a company or money fund with financial managers making investment decisions. The Objective of Equity Investors is to capitalize by later selling their ownership interests in the business once it grows and becomes more valuable. As part of this process, both angel investors and venture capitalists will often serve as members of the Board of Directors or an Advisory Board of the funded business venture. In these roles, the investors take an active role in the business. Their involvement is generally the subject of Corporate Governance procedure. Now, we need to discuss the types of equity interest that founders and investors will want or require.
What are the Types or Characteristics of Ownership Equity?
The type of equity used to fund a business venture will depend upon the type of venture and the requirements of the prospective owner providing value in exchange for the ownership interest. As previously discussed, basic company ownership interest for an LLC is the membership unit. Membership units may be divided into classes with specific ownership rights, such as voting and entitlement to profits. Later, we discuss other, more complex, LLC interests that are similar to ownership in our material on Equity Incentive Plans. Here we discuss the basic rights of holders of membership units to a Share of Company Profits or Losses. While the members may be entitled to the profits of the LLC, it does not mean that these profits will actually be distributed to them. Distributing profits is determined by the operating agreement or member vote.
- Note: When an LLC is taxed as a pass-through entity (Partnership or S-Corporation), then taxing a member on profits that they do not receive from the LLC can create another situation of “Phantom Income”.
Corporate equity is known as shares of stock. Like classes of membership unit, stock is generally split into Common and Preferred Shares. Preferred shares may take on any number of characteristics allowing for unique ownership rights. Third-party, professional, equity investors often demand some sort of preferred shares. These demands will often determine what type of shares the company will authorize and distribute. The most common characteristics or types of preferred shares demanded by investors are: Preferred Convertible Shares, Preferred Liquidation Preference, Participating Preferred Shares, Participating Convertible Preferred shares.
- Note: Owners, when reorganizing and planning to distribute shares to angel or venture capital investors, generally distribute common shares to themselves while the investors receive a Class of Preferred Share. Sometimes, however, they will authorize and distribute special classes of founder’s equity (a sort of preferred share), such as Founder’s Stock, Class F Stock, or Class FF Stock.
Generally, all equity interests issued to investors in a company is Restricted Equity that cannot be readily traded to others. This is done to meet the requirements for Private Placement of Securities under the Securities Act of 1933. Now that you understand the types of ownership interests to be distributed, let’s go through the process of getting those interests in the hands of owners.
The Process of Distributing Equity to Founders and Investors?
As we said earlier, the distribution of business equity to owners in exchange for cash or property is achieved through contracts known as Subscription Agreements (generally used prior to company formation) and Equity Purchase Agreements (used after the company is organized). First, however, the types of ownership interest being purchased must be included or Authorized in the LLC operating agreement or in the corporation’s articles of incorporation and bylaws. These purchase agreements, in conjunction with the terms laid out in the LLC operating agreement or corporate bylaws, will contain all terms relevant to the purchase of equity, including limitations on ownership such as: Rights of Redemption and Rights of First Refusal.
In an LLC, the founders will generally approve their approve their distribution of interest as part of the original operating agreement. They rarely use a unit purchase agreement. In an established LLC, on the other hand, the members will generally vote to enter into these agreements with perspective purchasers of membership units. This can be done through unanimous consent or via vote during a member’s meeting. The operating agreement will lay out whether majority, supermajority, or unanimous approval is required. Once approved, the LLC units are distributed to members. The LLC may authorize Membership Unit Certificates and the ownership is recorded in the Capitalization Table included in the LLC Agreement.
- Note: Often, LLCs do not actually authorize printed certificates. Rather, ownership is tracked solely in the LLC’s capitalization table.
In a corporation, entering into equity purchase agreements with company founders on behalf of the company is the board’s responsibility and is the subject of Corporate Governance procedure. As such, the initial board of directors (appointed by the incorporator) will Take Actions approving the stock subscription agreements with founders. At the same time, these founders (who are the initial Shareholders) will approve the actions of the board through Unanimous Consent of Shareholders or via Resolutions at an Initial Meeting of Shareholders. Now the shares of equity (which may be in the form of Stock Certificate if so authorized) are issued to the owners. The issuance is recorded in the Corporate Records. The shareholders will generally sign a Consent to Transfer appointing the corporate secretary as their agent for transferring ownership of the shares.
Now you know the process for getting shares into the hands of founders and investors. This process gets a little more complicated when issuing equity to employees or contractors to compensate them. So, let’s visit that issue next.
How can I distribute equity to Employees or Service Providers?
Often, a company will want to preserve cash and will compensate employees or contractors with ownership interests (or similar interests) in the business. To begin this process, the company will come up with an Equity Compensation Plan.
In an LLC, the company may include the equity compensation plan in the LLC operating agreement or keep it as a separate plan voted upon and adopted by the members. The LLC may employ plans allowing for compensation through Restricted Membership Units, Unit Options, Profits Interests, Unit Rights, or Unit Appreciation Rights plans. Each of these types of ownership (or ownership-like) interest has characteristics that may make it beneficial to the company or the member. The LLC will then go through the process of member voting to approve specific agreements with employees or service providers that grant them ownership of an interest.
Issuing an equity interest in a corporation is a bit more complicated. The company must first come up with an Stock Plan, which must be voted upon and approved by the board of directors and shareholders. The voting process can be down by unanimous written consents or through resolutions at director and shareholder meetings. Note, the issuance of equity as compensation is governed differently than Employee Stock Ownership Plans (ESOP), which are similar to employee retirement plans. The corporation may authorize and make Restricted Stock Awards of common or preferred shares. More commonly, however, the company will issue not issue actual stock; rather, it will issue Stock Options. This may happen as part of an Incentive Stock Option Plan or Non-Qualified Stock Option Plan. Other arrangements that do not involve the distribution of stock or options, but grants ownership-like rights to shareholders are: Stock Appreciation Rights, Performance Shares, and Performance Units. The company will specifically reserve a number shares (or other equity-like interest) as part of an Equity or Options Pool to draw from in compensating employees or contractors. When the interests in the company are granted, they may be granted outright or subject to a Vesting Schedule, that lays out a time table for when the employee or contractor actually receives ownership of the interest. All of this must be tracked as part of the business or corporate governance process. To use the language of the trade, you will need to be concerned with the company’s capitalization. Let’s dig into the capitalization topic a little further.
- Note: Special issues arise for the company and the employee when they receive company equity (or equity-like) interests in exchange for services. This is particularly true when the company seeks to have ownership of the interests vest over a period of time. Most notably, the company and employee must determine the value of the interest received for tax purposes. The primary tax considerations are discussed a little further below.
After Equity is distributed, what is the Company Capitalization?”
The total number and value of equity issued by the company are known as the Capitalization. The companies capitalization is recorded and tracked in a Capitalization Table, which lists the total number of shares or options that the company has Issued or are Outstanding on a “Fully Diluted Basis”. This becomes important for Business Valuation purposes when subsequent investors seek to purchase shares of the company. As such, any shares that have not vested by the time the company seeks additional equity financing from Angel or VC investors Vest Immediately at Time of Follow-On Financing.
Any Tax Issues When Using Ownership Interests to Fund the Business?”
Two tax issues of significance are: 1) providing services to the business entity or 2) transferring assets to a business entity in exchange for an ownership interest.
What are the Special Tax Issues in Providing Equity for Services?”
IRC 83(a) imposes tax liability when a partner or shareholder contributes services to a partnership-taxed entity or corporation in exchange for an ownership interest. Receiving ownership equity for services is known as, “Phantom Income”, as the employee does not actually receive cash for her efforts.
Whether distributing equity or options in exchange for the owner’s services, the equity may not immediately transfer to the owners. The equity interest is subject to a Vesting Schedule. This scenario is very common after a company receives equity financing from third parties. Per IRC 83(a), if shareholders do not actually receive ownership of the equity, they do not have tax liability until the stock vests. IRC 83(b) allows the shareholder to “recognize” and pay taxes on the value of unvested shares when awarded, allowing the shareholder to lock in a low basis in the stock before it increases in value.
The next tax issue is, how much is the stock worth at the time of award or vesting? This will be the amount of compensation taxable to the shareholder and used as a deduction for the corporation. Section 409A governs the valuation of stock option awards from the corporation. ASC 718 is an accounting rule that guides the corporation in valuing stock options for purposes of recording a deduction for employee or contractor compensation expenses.
Special Tax Issues in Providing Equity for Contributed Property?
IRC 1231 states that an individual incurs tax liability for gains when selling business property, including when appreciated property (property that has risen in value) when transferred to a corporation in exchange for equity ownership. IRC 721 allows for the deferral of recognition of gain on assets contributed to a partnership-taxed entity. Also, IRC 351 may defer the recognition of taxes for a contributing shareholder. It is important to understand that these types of transfer affect the Partner’s Tax Basis in the Partnership and the Partnership’s Basis in the Property, as well as a Shareholder’s Tax Basis in the stock and the Corporation’s Basis in the contributed assets. Special issues also arise when cofounder Contribute Intellectual Property in Exchange for Equity.
What do I do after my entity is set up?
Setting up the business entity and structuring ownership is just the first step in getting your business started. The following are some additional considerations or requirements.
Do I need any permits or licenses?
Once you have an established business entity, the next step before beginning to carry on business is to Obtaining a Business License. You must get his permission from any locality where you will carry on operations. Other considerations are temporary Business Permits and Occupations Licenses for carrying on certain types of trades or crafts.
How do I set up to hire employees and pay taxes?
An employer faces all sorts of tax requirements from the federal, state, and local governments. The first step is to get an Employer Identification Number from the IRS and state Department of Revenue. This becomes necessary when you form any business entity other than a sole proprietorship. Think of this as your business social security number. It is how you will withhold and pay income taxes and Self-Employment or Payroll Taxes. The IRS and most states have the ability to make online payments. Most businesses employ an accounting software, such as QuickBooks, Peachtree, or FreshBooks, that allow you to automatically withhold the appropriate taxes and transfer them to the appropriate taxing authorities. You will also need to register for a separate Sales and Use Tax Number if you sell products in a state.
Naming your business and protecting the name?
There are lots of marketing considerations for Naming Your Business. Once you select a name, however, there are several things to do to Protect Your Business Name until it is secured. One of the most important of these is to secure the appropriate Website URLs and Social Medial Handles to represent your business. You may also consider Trademarking a Business Name or logo as a manner of protection against competitors and counterfeiters infringing upon your brand.
Any property and land issues?
Choosing a Location (& Bldg) are important marketing considerations for the business. Equally important is the decision to Lease or Purchase the Commercial Property. Both of these decisions involve strategy and cost considerations. Another important consideration is that you review the local Zoning Requirements or restrictions on the property. You don’t want to find out that your type of business is prohibited by local law. Lastly, do a title search and research any other potential Private Restrictions on Land Use.
Should you have insurance?
Risk is an integral part of operating a business. One way to reduce the negative affects of specific risk is to purchase insurance coverage. There are various types of coverage. You should learn how business insurance works and take the time to identify potential risks specific to your business activity and address the Business Insurance Considerations.
How to make bank account and credit arrangements?
Once you have your name, business entity, and tax id numbers, you will need to Establish a Business Bank Account. This is crucial for maintaining the separation necessary to limited personal liability for business debts. You will also want to develop a plan for Building Business Credit. This will be instrumental in establishing vendor accounts and seeking future business loans. You will also want to consider what will be your Payment and Credit Policies. Customers will need to know how and under what terms they can pay for your value proposition.