Starting a new business is an exciting and challenging process, but you should never overlook the small details. Entity selection is a crucial part of proper business planning, especially for startups. The entity type you choose will affect your business’s tax, liability protection, among other things.
Why Form an Entity?
LLCs, C-Corps, and S-Corps offer several advantages, including liability protection, tax advantages, and easier access to capital. These benefits make it a crucial development step for most startups and businesses.
Many businesses start as sole proprietorships and transition to an entity structure as their business grows.
What Should Startups Consider When Forming an Entity?
You should consider several areas when deciding on an entity structure for your business.
Number of Owners
Businesses with fewer owners may prefer a more straightforward entity structure that offers simplicity and ease of management. For instance, a limited liability company (LLC) can be an excellent choice for businesses that want to keep things simple while still enjoying the benefits of limited liability protection.
On the other hand, businesses with many owners or investors may want an entity with more flexible ownership options. A corporation with easily transferable shares can be a good option as it allows for easy buying and selling of ownership stakes.
Potential Liabilities
Some businesses are more prone to legal liabilities than others. For example, businesses dealing with hazardous materials are more likely to face environmental lawsuits. Similarly, a business that provides professional services could face malpractice claims.
These types of businesses should prioritize liability protection to minimize the risks of potential lawsuits and financial damages. By forming an entity such as an LLC or a corporation, these businesses can limit their personal liability and protect their personal assets from business-related legal issues.
Growth Outlook
Small businesses that do not anticipate significant growth can often manage with a simple pass-through entity structure, such as a sole proprietorship or a partnership. These structures offer a relatively easy and inexpensive way to start a business and do not require extensive legal and regulatory formalities.
However, for startups hoping to scale and grow into larger companies, choosing the right entity structure is crucial. A corporation or LLC with the ability to issue stock or attract outside investors may provide the flexibility and capital necessary to fund growth and expansion.
Tax Planning
Corporations can offer more flexible tax options for ownership, including the ability to issue different classes of stock and provide benefits such as stock options and grants to employees. However, corporations also face a double taxation issue.
Corporate income is taxed at the corporate level and then again when it is distributed to shareholders as dividends. This often results in higher tax costs for the business and its owners.
In contrast, pass-through entities like LLCs and S-Corps offer simpler tax planning options but with fewer tax benefits. Income and losses are passed through to the business owners and reported on their personal tax returns, avoiding the double taxation issue that corporations face.
However, the pass-through structure may not provide the flexibility that some businesses require.
Pass-Through Entities
Certain entities pass their income to their owners’ tax returns. We call these types of organizations pass-through entities. In this structure, owners report and pay taxes on the business’s income on their individual return.
Pass-through entities are simpler and are often favored by smaller businesses with fewer owners. The following structures are considered pass through entities:
Limited Liability Company (LLC)
Many small businesses prefer limited liability companies for their liability protection and simple tax planning. An LLC can have as few as one member and still provide the same liability protection as a larger business entity.
However, businesses hoping to solicit investors should consider avoiding LLCs because their ownership shares aren’t easily transferable. Additionally, LLCs offer limited tax planning options compared to corporations.
LLCs are more straightforward in terms of tax and legal compliance, but businesses with complex structures or growth plans may find them cumbersome.
S-Corporation (S-Corp)
An S-Corp’s structure is similar to a traditional corporation, but they have many rules pertaining to shareholders, stock issuance, and more.
S-Corp regulations limit the number of shareholders, type of stock issued, and much more. Read our article on S-Corps for more info.
Additionally, only U.S. residents can own S-Corp shares, so they can cause problems for businesses pursuing international investment.
Like other pass-through entities, S-Corps pass their income onto their owners’ personal tax returns based on ownership share.
Corporations (C-Corp)
A corporation is a separate legal and tax entity from its owners. One of the advantages of a corporation is that it’s easier to issue and transfer shares, and there are looser qualifications for shareholders than other business structures. This makes it easier to raise capital and attract investors.
Additionally, corporations offer more tax flexibility, as the corporation can retain profits and the owners can take salaries or dividends as they see fit. This allows businesses to manage their tax liabilities more efficiently.
However, corporations come with significant regulatory compliance requirements, including the need to file a separate tax return and undergo regular audits. These requirements can be time-consuming and expensive, and businesses need to be prepared to invest in legal and accounting resources to manage them effectively.
For startups hoping to list their shares on a public exchange, a corporation is a must. Public investors and regulators expect the transparency and accountability that comes with a corporate structure, and startups that want to attract outside capital need to meet these expectations.
Additionally, a corporation offers more options for raising capital through equity financing, as it can issue and sell shares to a wide range of investors. However, businesses need to be prepared to manage the reporting and regulatory requirements that come with a corporate structure, and to invest in the legal and financial resources necessary to meet these requirements.
What is the Best Entity for My Startup?
Entity selection is a complicated process. Consider your business’s size, number of owners, level of expected growth, and the liability potential before deciding on a structure.
Smaller businesses with fewer owners and lower growth expectations should consider an LLC or other pass-through entity. These entities offer simple tax planning and robust liability protection, with significantly less compliance requirements.
However, businesses with big growth plans should consider forming a corporation. Corporations offer more flexibility in ownership, share issuance, and income disbursement. It’s also one of the most flexible options for business seeking to raise capital and attract investors.
Corporations also offer strong liability protection and the option to retain profits. However, they come with significant compliance requirements, so be prepared to invest in legal and accounting resources to meet the lofty compliance standards.
Final Thoughts
Ultimately, the choice of business entity should be based on a thorough evaluation of the business’s needs and goals, taking into account factors such as liability protection, tax planning, ownership structure, and growth potential. Consulting with legal and financial professionals can help businesses make an informed decision and ensure that they are setting themselves up for success.
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