What’s the Best Entity Form for Your Start-Up?

Choosing the best business form is one of the most important preliminary decisions for a new business owner. There are several choices: C Corporation (C-Corp), S Corporation (S-Corp), Limited Liability Company (LLC), Limited Liability Partnership (LLP) or a Partnership. There are advantages and disadvantages to operating under each of these forms. In choosing the proper form, it is important to consider a number of tax and non-tax factors, including liability, taxation, management, and ownership structure.

a. Liability

The first factor to consider is owner liability. Different entity forms offer varying levels of liability protection to their owners. The purpose of liability protection is to restrict potential owner liability to the amount of one’s investment. The importance of limited liability can be illustrated by an example. If a business is operating in a form that does not offer liability protection, the owners’ personal assets, including their houses, bank accounts, and personal property, are fair game to a creditor of the business. This problem can be avoided by organizing a new business as a Pennsylvania entity that provides liability protection.

Under Pennsylvania law, the broadest form of statutory liability protection is afforded to shareholders of corporations (C-Corps and S-Corps) and members of LLCs.[1] Shareholders and members are protected from both the contractual and tort liabilities the business incurs. This broad protection means that members and shareholders are protected from personal liability for all business debts or obligations.

LLPs and partnerships offer weaker forms of liability protection. LLP’s provide what is termed “partial-shield” protection. Partial-shield protection insulates partners from liability for the tortious acts of their partners (e.g. malpractice), but does not protect partners from personal liability for the contractual liabilities of the LLP. General partnerships do not offer any liability protection to their partners. A partner in a general partnership is subject to unlimited personal liability for any obligation or liability incurred by his partners, the business, or the partnership’s agents.

In order to best protect the owners, start-ups should organize as an LLC, C-Corp, or S-Corp because these forms offer both contractual and tort liability protection. There is no real disadvantage to eliminating the partnership form for liability reasons because an LLC can still exploit the tax advantages of the partnership tax regime, as discussed below. In addition, limited liability will be helpful when seeking investors. Investors are more likely to invest in a company that provides liability protection, and in reality, investors may only be willing to invest in a new business if it offers liability protection.

Finally, on a cautionary note, a business that is not registered in some entity form is treated as either a general partnership (multiple owners) or a sole proprietorship (single owner). These forms do not provide any liability protection, and therefore, each owner is subject to unlimited liability for the debts and obligations of the business. Thus, every business should be registered as soon as possible in order to protect the owners’ personal assets.

b. Tax Considerations

The next area to consider is taxation. The three remaining entity possibilities, the C-Corp, S-Corp, and LLC, are all treated differently for tax purposes.

i) C-Corporation

C-Corps are considered separate taxable entities under the Internal Revenue Code. The most well-known ramification of this separate existence is that a C-Corp’s income is taxed twice, first when the income is earned at the corporate level, and again when income is distributed to shareholders. More importantly for a start-up company, C-Corp status prevents a corporation from passing losses through to its shareholders. Thus, C-Corp shareholders will not be able to immediately take advantage of the start-up losses. However, as a C-Corp may carry over its losses for up to five years, the company will be able to offset corporate income when the business turns a profit.

ii) S-Corporation vs. LLC

The LLC form offers the greatest amount of tax flexibility because an LLC can elect to be taxed like a partnership or like a corporation. At the start-up stage, partnership tax treatment offers more advantages, but an LLC can elect to be treated as a corporation when that treatment becomes more beneficial. An LLC taxed as a partnership is treated as a “pass-through” entity. Similarly, a state law corporation that has elected to be treated as an S-Corp for federal tax purposes is subjected to “pass-through” treatment. Pass-through treatment allows business level income and losses to pass-through to the owners. Owners include their share of the business’s income and losses on their individual tax returns (termed the “distributive share”). The income is taxed at the owner’s individual rate, and the losses may be used as an offset against owner income derived from other sources. It is important to note that S-Corp shareholders and LLC members are taxed on their distributive share whether or not the entity actually distributes the money to them.

Generally, LLC and S-Corp owners may deduct their share of the business’s losses up to the basis of their stock. The key difference between LLC and S-Corp start-up situations is that the LLC offers higher potential upward bases adjustments. LLC members have the ability to increase their membership interests by their share of the LLC’s outside liabilities. Each member is treated as if he personally borrowed his share of the LLC’s obligations and contributed that amount of cash to the LLC. In contrast, S-Corp shareholders may not increase their basis by their share of the S-Corp’s obligations to third parties.

There are some disadvantages to the LLC form. Under the partnership provisions, an LLC member’s distributive share constitutes earnings from self-employment, and therefore, the whole share is subjected to employment tax. However, passive members, who do not participate in managing the LLC can generally escape from self-employment taxation. In contrast, the S-Corp can strategically categorize the distributive share to minimize the imposition of this tax (the ability to manipulate distributions to avoid employment taxes subjects S-Corps and their shareholders to frequent audits, which is another disadvantage). That being said, in a start-up situation, this disadvantage is minimal because most start-ups do not generate sizable revenue during their formative years.

Another significant tax drawback to organizing as an S-Corp is provided by the eligibility rules of Subchapter S. Under Subchapter S, a corporation will be ineligible for S-Corp treatment if the business: (a) has more than 100 shareholders, (b) has a shareholder who is not an individual (i.e. corporations, partnerships, or trusts), (c) has a nonresident alien as a shareholder, OR (d) has more than 1 class of stock

For tax purposes, organizing as an LLC is the best option for start-ups. Although both the S-Corp and LLC offer the advantage of “pass-through” treatment, the LLC allows members to deduct more losses because of the favorable basis adjustment rules. Furthermore, organizing as an LLC frees a start-up from complying with the S-Corp qualification rules. Finally, although the S-Corp can allow for self-employment tax savings, this factor will not be important until the business begins to generate profits.

c. Management and Ownership

Both the S-Corp and C-Corp must comply with corporate formalities, which may lead to increased costs and efforts. Corporations must draft articles of incorporation and bylaws, issue stock, and elect directors. Corporations must also hold shareholder meetings, keep meeting minutes, and generally operate at a higher level of regulatory compliance.

The LLC offers more management flexibility. The LLC is governed according to an initial document called the operating agreement. Although similar to a corporation’s articles of incorporation, an operating agreement is easier to modify as the business evolves. An LLC is either “member-managed” or “manager-managed.” In member-managed LLCs, members make the day-to-day decisions for the company. In manager-managed LLCs, members select managers to run specific parts of the business, or alternatively the business as a whole. The operating agreement will also delineate decisions that require a member vote. Under Pennsylvania law, voting power is per capita (i.e. each member gets a vote), unless the operating agreement states that voting shall be based on capital contribution (I suggest this option).

d. Pennsylvania Tax Considerations

The Pennsylvania tax code must also be accounted for in the analysis. C-Corps (and LLCs which elect corporate treatment) are subject to the corporate net income tax at a rate of 9.99%. S-Corps are subject to the 9.99% corporate net income tax only to the extent of built-in-gains, and S-Corp shareholders are taxed at the personal income rate of 3.07% on their distributive share. The members of LLCs which elect partnership treatment are taxed at the personal income tax rate of 3.07%.

e. The Best Entity Choice

Choosing the proper entity form can make or break a new business. Although all of the business forms discussed above have their own unique advantages, the LLC form is a cost effective solution for a start-up that wants liability protection, flexible tax perks, and flexible management options. Every situation is different, and we encourage businesses to consult with their tax professionals and attorneys before settling on a choice. The big take away: analyze the situation and choose a business form that will foster success.

[1] Note that under Pennsylvania law owners of a corporation are termed “shareholders,” whereas owners of an LLC are termed “members.”

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