The monetization of a business concept presents ambitious entrepreneurs with numerous considerations. However, with careful thought, founders can spend more time growing their business and less time worrying about whether they made the wrong decision when starting a startup. The main goal of any founder should be to choose the form of legal entity that will be consistent with their startup’s business model and that will serve as an attractive investment tool. The form of the unit not only influences the business decisions of the startup, but also determines the ownership structure as well as the obligations and duties of those involved in the business.
Founders are asked to avoid the “one-size-fits-all” approach, as two circumstances are never the same. In the United States, founders are allowed to conduct their business through a corporation (including an S corporation), partnership, limited liability company (LLC), or sole proprietorship. A corporation is a separate legal entity that is separate from its owners (known as shareholders or shareholders). A partnership is a hybrid entity where in certain situations it is viewed as a separate legal entity and in others it is not considered, e.g. B. Certain legal liabilities and taxes.
An LLC generally incorporates the best of business and partnership features by providing liability protection to its owners (referred to as members) and the flow control attributes of a partnership. Unlike the others, a sole proprietorship generally has no legal differentiation from its owner, which can be problematic for a startup as the sole proprietor has unlimited personal liability for business operations. While there isn’t a perfect answer for every situation, the discussion below contains a number of questions that every founder should consider when choosing the business structures available.
Who Owns the Business?
Startups can typically choose any legal form for their business, although specific rules and requirements may limit unit choices for some businesses. Sole proprietorship is only available to companies with a single owner. In addition, the federal income tax law limits the type and number of shareholders in S-companies.
For startups that are looking to raise institutionalized equity or one day want to go public, structuring the company as a company is desirable because the equity (referred to as stocks or shares) is easy and easily exchangeable. Prospective investors such as venture capital funds are likely to prefer a corporate structure to invest in as the fund may include investors such as pension funds, nonprofits and trusts that are subject to specific tax regulations.
However, some investors may prefer the partnership or LLC structures as the governing documents for such companies (referred to as a partnership agreement or operating agreement) have greater flexibility to be tailored to the owner’s expectations and requirements for investors (such as voting and economic rights) to become. etc.) and allow a more tax efficient distribution of cash (or property).
How is the company taxed?
For corporations (with the exception of S corporations, which have the flow tax attributes of a partnership), the corporation is subject to corporate income tax at the federal and, in many cases, state levels. Currently, the federal corporate income tax rate is a flat 21%, while state income tax rates vary significantly. (For 2021, the lowest corporate tax rate in North Carolina is 2.5%; the highest in New Jersey is a current high of 11.5%.) In addition, distributions by a company to its shareholders are taxable on dividend income to the recipient, taxed according to the individual income tax class of the shareholder. The federal and state level rates vary based on the recipient’s gross annual income.
Partnerships, S-Companies, LLCs, and sole proprietorships tax their income directly to owners who are taxable on the company’s income. By default, LLCs are taxed as a flow-through company. However, you can choose to be taxed as a business. However, some states may impose a corporate-level tax even though the startup is a flow-through company for federal income tax purposes. (For example, Tennessee levies franchise and excise taxes on certain companies structured as LLCs unless the company meets the requirements for an exemption.) Founders should consult their legal and accounting advisors to determine additional state tax obligations for which you may be responsible.
How will the company raise capital?
Aside from sole proprietorship, most structures can raise investment capital without various legal or tax restrictions, including through the use of equity (shared or preferred), debt (convertible or non-convertible), warrants, options and other derivatives. For startups that (at least initially) raise capital through family, friends, strategic investors and other high net worth individuals or family offices, an LLC offers the investor the opportunity to determine the conditions that the corporate form cannot dictate. For other investors who are simply looking for an investment in order to get a return on their investment, a company is more desirable because the main communication between the company and the investor is annual tax returns and notices from the general meeting.
Other considerations
In addition, founders should consider the legal and tax incentives available to the above structures. For certain companies that are classified as Qualified Small Businesses, shareholders can shield 100% of all capital gains on their exit from the business, as well as a tax-free rollover from one investment to another. This highly preferred exclusion only applies to certain companies, including most corporate startups. Similarly, pass-through business owners – such as partnerships, LLCs, and S-companies – can deduct up to 20% of their share of the company’s net income under applicable federal income tax laws, subject to certain requirements and restrictions.
Choosing the right legal form is an important decision for any startup. In all situations, founders should consult their legal advisers about the most suitable vehicle for their company.