What Legal Entity Makes Sense For Your Company?

When you want to start a new company, what do you do? Often times, people think it is as simple as calling their CPA to register a company, or calling an online legal service and selecting a legal entity that sounds good. Here at Signature Analytics, we have heard of clients using these services to start a company. While having a legal entity is your ticket to play in the business game, there are many other factors you must consider!

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To name a few, there are implications on your tax, personal asset protection, capital raise capability, and even exit strategy. First, you must determine what legal entity makes the most sense for your company. To start, let’s touch on the different types of legal entities:

Legal Entity Types

1. Sole Proprietorship
2. Limited Liability Company “LLC”
3. S Corporation
4. C Corporation

 

1. Sole Proprietorship

• Income on 1040 Schedule C
• Single ownership
• Self-employment tax on income
• Unlimited liability
• Cannot sell entity interest, only assets

As a sole proprietor, you file your business income as part of your personal tax return Schedule C, and you have to pay self-employment tax on your income. You have unlimited liability in the event of a claim against you.

2. Limited Liability Company (LLC)

• Articles of Organization, Operating Agreement
• Foreign owner(s) ok
• Treated as partnership unless election made
• Flexible to elect entity as C Corp, S Corp for tax purpose
• Limited liability to members’ capital contributions

An LLC allows you to have foreign owners/investors. For example, you may elect that the entity is to be taxed as a C Corp, S Corp, and you have liability limited to your members’ capital contributions. Please note that owners in an LLC are considered “members” not “shareholders.”

3. S Corporation (S Corp)

• Articles of Incorporation with annual shareholder meetings
• Limit on type of # of owners
• Corporate return filed
• Flow-through on income/loss to owners based on ownership %
• Limited liability to shareholders’ capital contributions
• Flexibility on sale structure

S Corp requires you to have an annual shareholder meeting. You also cannot have a foreign owner in S Corp. Corporate tax return must be filed and any income/loss will be flowed through to owners based on % of ownership. Liability is limited to your members’ capital contributions.

4. C Corporation “C Corp”

• Articles of Incorporation with annual shareholder meetings
• No limit on type or # of owners
• Corporate return filed
• No flow-through to shareholders
• Double taxation on $ to owners (salary or dividends)
• Limited liability to shareholders’ capital contributions
• Flexibility on sale structure (asset vs. stock)

C Corp has no limit on the number of owners, local or foreign. There is no flow-through of income/loss to shareholders, but there is double taxation on money distributed to owners in the form of salary or dividend.

For companies with a social calling, i.e. giving a part of their income for philanthropy purpose, they may elect to be a B Corp. A “B Corp” is essentially taxed like a C Corp but gives Board and Management legal protection as it might be perceived that they are not “maximizing” the shareholders’ value through their corporate giving. For all tax and legal implications on each entity, please make sure you talk to your tax or legal advisors, as the above is a quick overview and not meant to address each owner’s unique situation.

Preferred Entity Choice

Depending on many factors and timing, most investors ultimately favor C Corp status. So as your business continues to grow and/or you are planning to solicit capital infusion from accredited investors, you may want to consider future conversion of your current legal entity to a C Corp. Please note that conversion may be more than just completing a few forms, so it is crucial you talk to your tax advisors first to confirm any tax consequence.

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It is essential to get your books right from the start! While choosing a right legal entity is important and thinking about an exit strategy is exciting, at the end of the day, if you don’t run your business properly, nothing else matters. There will be no exit strategy to talk about! With financial discipline, you could leverage your accounting and finance team to help you achieve success faster and better. At Signature Analytics, we can evaluate your accounting and finance needs and help determine the best strategy for your company, no matter what stage your business is at. Contact us today to learn how we can complement your existing team or act as your entire Accounting department!