Choosing the proper entity selection for your start-up venture is crucial. This is how you will protect yourself, as the founders, and additionally, engage interest from potential investors. The three main entity types are LLC's, S-Corp's, and C-Corp's.
An LLC stands for a Limited Liability Company; they are very simple to set up and are the most popular today. This entity selection provides personal liability protection and is formed under state law. LLC's are formed by filing the Articles of Organization with the secretary of state. Additionally, the Operating Agreement is a combination of bylaws and other agreements into one document. The owners are called members, and they owe a fiduciary duty to the entity and the other members. There are no shares and no stock, but rather, it is called units or interest. LLC's have what is called pass-through taxation. Rather than the LLC itself paying tax, the members withdraw a salary and pay a personal tax on it. The organizers of a company often choose the LLC option because it is often tax advantageous. The members may pay more in personal tax but, in the end, will net more money since the company is not taxed as well.
Corporations are a little bit more complicated. The corporation is formed when the Articles of Incorporation are filed with the secretary of the state. Corporations must follow the state corporate laws in which they are incorporated in. The owners are called shareholders, and the shareholders elect the board of directors who are responsible for the corporation. The board has a fiduciary duty of care and loyalty to the corporation and its shareholders. A corporation must have a board of directors, and the board elects officers, such as, president, secretary, and treasurer, who run the corporation on a day-to-day basis. A corporation can be taxed in two different ways.
S-Corporations are taxed similar to an LLC. There is pass-through taxation where the corporation does not pay tax on its income, instead, the shareholders are paying tax based on the amount of shares they own.
C-Corporations are taxed differently. The corporation itself pays taxes on its income, and it is not passed through to its shareholders. If the C-Corp distributes money (dividends) to its shareholders, the shareholders pay tax on it. For this reason, a C-Corp has what is called double taxation. This is where the business pays tax on its income, and then the shareholders pay tax on its dividends. This type of structure often does not make sense for small businesses.
Furthermore, an S-Corp must be a domestic entity, 100 or fewer owners, and all of its owners must be individuals and not entities. S-Corps can only issue one type of stock, common stock. C-Corps, on the other hand, do not have the same restrictions as an S-Corp, and often are a better choice for companies, particularly as they grow and expand their shareholder base. Moreover, C-Corps may issue two types of stock, common and preferred. This allows for more flexibility when raising money from investors, some of whom will opt for preferred shares which convey additional rights relative to common shareholders. Because investors in early-stage companies look for these enhanced rights, the C-Corp structure is popular with companies that expect to raise money, particularly those looking to raise several rounds of funding.
In the early stages, it may not make sense for your business to be a corporation. However, switching from one to the other as needed is fairly simple: if you are filed with the secretary of state one way, all it takes is filing the proper paperwork to switch your business from an LLC to an S-Corp, or an S-Corp to a C-Corp.
This post was written by Sam Sherman and Jeffrey Camp. Mr. Sherman is member of the Cane Angel Network investment team and will receive his JD and MBA in May 2022. Mr. Camp is the Managing Director of the Cane Angel Network.
