Most founders have some idea of the types of legal entity they have to choose from when creating their new company. Who hasn’t heard of a corporation or a limited liability company (LLC)?
Slightly less recognizable are entities like general partnerships (GPs), limited partnerships (LP's), sole proprietorships, and non-profit corporations.
But what about those more “exotic” choices - professional corporations (PCs), professional limited liability companies (PLLCs), and even limited liability limited partnerships (LLLPs) (holy cow)??
As if that's not enough, where do “C-corporations” and “S-corporations” fit into all of this? Well… they don’t, really. But more on that later.
You can see why any business owner has the right to be confused about choosing an entity type. That's where a law firm that represents only startups and entrepreneurs can be so valuable. They can offer customized advice and documentation that you just can't get from an online service.
Here's what a good startup lawyer should be able to tell you:
THE AWESOMENESS OF LIMITED LIABILITY
Your first question might be “why do I need an entity at all (and what the heck is an ‘entity’ anyway)?”
“Entity” is how lawyers describe corporations, LLCs, and all of the other types of legal business forms mentioned above.
The best reason for running your business as an entity? It’s because you probably like your car, and your house, and your priceless collection of Pink Floyd on vinyl. If you run your business as an entity, all of those personal items are protected if your new business fails and owes money to a landlord, material supplier, contractor, or other creditors. Without an entity between you and your business’s creditors, those people can sue you personally and take your records AND your record player.
But if your company is a corporation, LLC or other entity with limited liability, those creditors can only go after the assets of the company (in most cases). Your classic convertible is safe.
Using an entity to run your company has some other benefits as well - it can be easier to get business banking services, raise money, buy (or be bought by) another company, and enter into contacts. But the number one reason is the beauty and safety of limited liability.
CORPORATIONS - THE GRANDDADDY OF BUSINESS ENTITIES
Cast your mind way back, so far back that avocado toast wasn’t even a thing yet, and you’ll get to the 1790s. That’s when corporations took off in the U.S., and there’s a reason they're still the dominant business form for most companies, particularly large ones: there’s no mystery about how corporations work.
Every corporation is owned by its shareholders (or stockholders; the terms are interchangeable), managed by one or more directors (the “Board of Directors” or sometimes just the “Board”), and operated by its officers (President, Secretary, etc.)
For this reason, professional investors (think: venture capitalists) tend to prefer investing in corporations. It’s also possible to grant employees stock options (the ability to buy stock in the corporation in the future) to encourage them to do their best work and to stick around. Stock options just don’t work well in LLCs, for a number of reasons.
On the flip side, the well-defined structure of a corporation makes them less flexible and means there are more corporate “housekeeping” matters to occupy your precious time and attention. And as always, taxes come into play: a corporation’s earnings may be taxed twice (yikes!), once at the corporation level, and again when earnings are distributed to the shareholders. (But see the discussion on S-corporations, below.)
Here’s the skinny on corporations:
PROS of a Corporation:
Limited liability
Professional investors generally prefer corporations
Easy to issue equity incentives (stock or stock options) to employees and others
CONS of a Corporation:
Double taxation (without an S-election)
Limited flexibility in management
Generally more complex to manage than an LLC
LLCS - THE CORPORATION’S YOUNGER, WILDER SIBLING
Corporations were almost 200 years old when the limited liability company came onto the business scene in the 1990’s. LLCs are basically state-approved contracts creating companies with the key benefit of limited liability (hence their creative naming) but much more flexibility in management and ownership structure than corporations.
LLCs are owned by their members and are managed either directly by those members or by managers. If compared to corporations, members are similar to shareholders, and managers are like a combination of directors and officers.
An LLC's major difference from a corporation is that the contract governing the LLC (usually called an Operating Agreement or an LLC Agreement) can say pretty much whatever the owners want it to say. So the financial terms of investment, tax allocations, and cash distributions, as well as who makes the management decisions in the company, can be more or less anything the members agree to. That's not generally possible with corporations.
Perhaps most beneficially, LLCs are usually subject to pass-through taxation by the IRS, which means the company’s profits (and losses) are “passed through” directly to the owners - avoiding the corporation’s double taxation issue described above. This is the same way partnerships are taxed.
While the LLC’s flexibility is appealing to some, it does have the drawbacks of being unattractive to many investors, and making it so awkward to issue incentive compensation (stock options) that it’s generally not even worth trying.
PROS of an LLC:
Limited liability (just like a corporation)
Single level of taxation usually means tax savings
Flexibility in financial and management means the owners can decide exactly how they want the business to run
Fewer time-sucking administrative requirements than corporations
CONS of an LLC:
Professional investors generally prefer corporations
Nearly impossible to issue equity incentives to employees and others
HOW TO CHOOSE: CORPORATION OR LLC
If you’re still unsure, take a look again at the lists of pros and cons above under the corporation and LLC sections. If you meet criteria for either entity and see benefits in each, the LLC offers more flexibility with fewer administrative headaches than a corporation, plus the automatic benefit of pass-through taxation, so it’s generally the right choice for new small businesses.
TAXES ALWAYS COMPLICATE THINGS: THE S-ELECTION
The double taxation problem of corporations does have a solution - but it’s one that comes with significant limitations (of course, darn that IRS...)
To see if you may want to make an S-election, keep an eye out for an upcoming blog post from Fisher Corporate Law: What's an "S-Election" and Why You Should Care. (We'll link it here when it's posted.)
SOLE PROPRIETORSHIPS ARE EASY… AND RISKY
A quick note about sole proprietorships, which you may have heard of. A sole proprietorship is just running your business without an entity. It’s easy, fast, and usually free, but it’s missing the key benefit of limited liability, and for this reason it’s usually not a good choice.
That said, there are few businesses where the risk is so low that using a sole proprietorship may be a reasonable choice in order to save on filing fees and administrative work of setting up and operating an entity. Be sure to talk to your lawyer if you think this may be a good choice for you.
SOME FINAL THOUGHTS
At Fisher Corporate Law, we preach simplicity whenever possible, and that certainly goes for your choice of legal entity. A corporation (with or without an s-election) or an LLC will be the right choice for more than 90% of new companies. And if you decide in a few months or years that you want to make a change? No problem - it is usually possible to convert one type of company to another, or to change an s-election if you need to.
Want to know more about starting your business on solid legal ground? Schedule a consultation with an attorney at Fisher Corporate Law today.
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