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Legal Entities for Start-Ups


Most businesses start as sole proprietorships or partnerships. Partnerships are either general or limited or general for a specific purpose. Any limited partnership may involve securities issues. One advantage of the partnership entity is that it can be formed with a letter agreement. Most partnerships soon evolve into LLCs to take advantage of limited liability. 


Two of the most common early legal business structures are the limited liability corporation (LLC) and the S Corporation. There is also the C Corporation. An LLC usually offers advantages over both at the outset. An LLC allows a business to set up an ownership structure that makes sense for liability and tax purposes. Unlike an S Corp in which the share structure mirrors the amount invested by each shareholder, an LLC has flexibility. This is important as profits flow through an LLC and hence are taxed to the owners. Profit distribution does not have to mirror percentage investment in the company.


  • Transfer of Ownership

In an S Corp, shares can be sold, gifted or willed to others, creating changes in ownership structure and possible leadership and direction issues. In an LLC, if it is dissolved, upon the bankruptcy or death of an owner or following business disagreements, LLC owners can regroup and simply set up a new LLC.


  • Paperwork

All corporations, including S and C Corps, are required to hold regular shareholder meetings and memorialize the matters covered in such meetings. A board of directors makes decisions by means of formal documented resolutions. An LLC has no need for minutes, resolutions or meetings. This reduces time spent on administration paperwork as opposed to strategic planning and execution of the business plan.


Many businesses start out as LLCs and then change to a C or S corporations.


  1. LLC

An LLC allows a business to set up an ownership structure that makes sense for liability and tax purposes. Unlike an S Corp in which the share structure mirrors the amount invested by each shareholder, an LLC has flexibility. This is important as profits flow through an LLC and hence are taxed to the owners. Profit distribution does not have to mirror percentage investment in the company.


  • Transfer of Ownership

In an S Corp, shares can be sold, gifted or willed to others, creating changes in ownership structure and possible leadership and direction issues. In an LLC, if it is dissolved, say upon the bankruptcy or death of an owner, or due to business disagreements, some owners can regroup and simply set up a new LLC.


  • Less Paperwork

All corporations, including S and C Corps, are required to hold regular shareholder meetings and memorialize the matters covered in such meetings. A board of directors makes decisions by means of formal documented resolutions. An LLC has no need for minutes, resolutions or meetings. This reduces time spent on administration paperwork as opposed to strategic planning and execution of the business plan.


S Corporation


The S Corporation is a popular structure for small businesses in part because the company is taxed like a sole proprietor or partnership. The company itself does not file its own taxes; all company profits and losses are "passed through" and reported as personal income of the shareholders, just as, in the case of an LLC, to the members.


Business Formality

S Corporations involve compliance obligations which can be initially burdensome for a founder. If you incorporate as an S Corporation, you need to set up a board of directors, file annual reports, make other business filings, hold shareholder’s meetings, keep records of your meetings, and operate at a higher level of regulatory compliance. LLCs use an informal operating agreement. If you want less red tape and formality, the LLC is for you, at least in the first days.


Who Can Be a Shareholder?

The S Corp cannot have more than 100 shareholders. Obviously, this is not relevant to most start-ups. All individual shareholders of an S Corp must be U.S. citizens or permanent residents. Also, if you want an LLC to be a shareholder you cannot form an S Corporation and you probably should opt for an LLC until you are ready to be a C Corporation.


C Corporation

  • Taxation

The most obvious problem with C Corporations is that they do not offer the pass-through advantages that LLCs and S Corporations do. The corporation will pay tax on any profits and employees pay taxes on salaries, and if there are any profit distributions by means of dividends owners will be taxed (again). The tax code is not friendly to a C-Corporation that wants to provide profits to shareholders. If those shareholders are also employees, there will three different points of taxation!


LLCs look like they have only one point of taxation but in reality there is a second point. There is self-employment tax and income tax. Paying self-employment taxes is still better than paying C Corp taxes because the C Corp needs to pay an employment tax on salaries (the same as a self-employment tax).


  • Hold profits in or not

With the C Corp you can hold profits in the corporation rather than pay them out. If you are profitable, you will want to hold profits in and pay yourself a minimal salary. If you expect to experience losses, as is usually the case in early stage companies, the LLC has advantages in that LLC loses can offset other income. A C Corp will carry those losses (for credit against future profits) but the owner, as a tax-paying employee, does not get to make use of them. He or she will have additional W-2 income.


  • Compare to LLCs

The big drawback to LLCs is the problem of how you deal with the ownership structure. LLCs do not have shareholders and shares of stock; instead they have "members" and "units.” In an LLC each member is the same as every other member. Everyone is working under the same operating agreement: investors, the founder or founders, and any employees who have been given (or expects to be given) ownership.


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