By Jacob Osburn
You have the idea for the “Next Big Thing.” You workshopped the idea with friends and, if you’re very brave, family, and now you are ready to go out and get some investors to make this idea become reality. Not so fast. Along with the seemingly endless amounts of decisions you must now make as a new entrepreneur, one will have a huge impact on the future of your company: What business entity should I choose?
The C-Corporation (C-Corp) is the go-to entity choice for many entrepreneurs. It provides liability protection to its investors, effectively limiting the risk of loss only to those amounts invested. Also, a C-Corp can offer many different types of stock to investors, including preferred shares which will allow these investors to get the first piece of the pie when dividends are paid or a return on investment is made. A C-Corp can also offer various types of compensation, such as stock options, in order to hire and retain top talent when actual liquid cash for higher salaries is not available. The major downfall of the C-Corp is that it does get hit with double taxation. First, any net income is taxed at the entity level and then the shareholders pay tax on the dividends paid out from the company. Double tax? No thanks. So, what is the alternative?
The S-Corporation (S-Corp) swoops in to save the day! It enjoys the same liability protections afforded a C-Corp but avoids double taxation by passing the items of income and loss directly out to the shareholder. Of course, the IRS would not allow this without attaching some strings, and those strings can feel more like anchors. An S-Corp is limited to only 100 unique investors, those investors must be US Citizens and cannot be C-Corps, or pass-through entities, and only one class of stock can be issued. All these factors conspire to make the S-Corp an almost non-starter if you are seeking large investors or venture capitalists. But before we go back to the C-Corp, there is another potential entity choice to consider.
The Limited Liability Company (LLC) is currently the most popular entity choice. They are as flexible as a C-Corp with their ability to offer different classes of membership and incentive-based compensation, while maintaining their liability protection. Also, they offer the pass-thru taxation benefit of an S-Corp without the restrictions on investors. There are a few key differences between an S-Corp and LLC when it comes to taxation. For instance, an S-Corp may pay and deduct salaries to its shareholders if they are reasonable and the income that passes thru is not subject to self-employment tax. Conversely, an LLC cannot pay salaries to its members and the income passed out is subject to self-employment taxes. So, maybe the LLC is the choice for you? Yet again, a venture capitalist will have something to say.
Venture capitalists (VCs) will almost exclusively require the companies they invest in to be formed as a C-Corp, for all the reasons noted above. Even though an LLC can provide many of the same benefits, the fact that the income is passed through to the owners is actually a detriment, as many VC’s are interested in investing in companies that will have some sort of liquidity event in the future. One option to help get your company off the ground is to form an LLC and then to convert to a C-Corp down the road when you start seeking larger investors or venture capitalists. This allows you to utilize the benefits of pass-thru taxation in the early stages of your business, and this conversion can be as easy as checking a box on your tax return (it is a separate form) to elect to be taxed as a C-Corp with the upside being that this conversion will most likely not be a taxable event as long as your assets exceed liabilities at the time of election.
We have only scratched the surface on entity choice. While we provided some basic reasoning and strategies, it’s important to understand that everyone’s situation is unique. Contact a Snyder Cohn associate to see how we can help you during this exciting and important time in your business’s life.