Being an entrepreneur is an exciting and challenging undertaking. You have great ideas, lots of enthusiasm, but sometimes you don’t know what you don’t know. Therefore, it’s important to seek good financial and legal advice.
When seeking financial advice, remember there is a difference between finance and accounting. CPAs and accountants are more focused on what has been done in the past. A finance expert is more focused on where you are going. For example, let’s say that you want to create a Private Placement Memorandum (PPM). You’ll want to seek financial and legal advice to guide you through the best way to create a PPM for your company.
Legal advice is also necessary to help you determine the company structure for your new venture. There are a variety of legal entities you can establish, but you should first think through your long-term objectives. If, for example, you plan on funding your new business solely with friends and family, they you may want to create a Limited Liability Company (LLC) or a sole proprietorship.
On the other hand, if you plan on raising venture capital, then you’ll want to create a C corporation. Investors are most interested in C corps., which have board of directors and stock. If you have a subchapter S corporation, you probably will need to convert it to a C corp. when investors get involved. However, don’t worry too much about the details; your funding source will help dictate how to structure the company, stock, etc.
The following is a brief description of the various company structures available. You also can find online sources that can provide more details and guidance.
A Sole Proprietorship is the simplest business form, and does not even involve a separate legal entity. You may easily file a DBA (doing business as) with the state for a small filing fee. In addition, no complex administrative issues are involved, and there is no double taxation. It can be the best form for a small business where it is unlikely that the business will incur any significant debt or could be sued for a business related matter. This is an important point because a separate entity is not being formed, and thus the owner is liable for all of the business’s actions.
In many ways, a General Partnership is quite similar to a Sole Proprietorship, except that there may be more than one owner. Like the Sole Proprietorship, it is fairly easy to administer, there is no double taxation; however, there is the risk of unlimited liability to the owners. It is also more complicated in that the arrangements between the owners (the partners) must be defined, usually in a partnership agreement. The partnership agreement usually specifies, among other things, how income is allocated, and what happens if one of the partners wants to leave the business or dies.
Closely related to a General Partnership is a Limited Partnership. A Limited Partnership is composed of one or more general partners and one or more limited partners. Although the general partners still have unlimited liability, the limited partners do not, so long as they are passive investors and do not have an active role in the operations of the business. Their liability is generally limited to the amount of their original investment. Many times a separate Corporation is formed to act as the general partner to further reduce the unlimited liability risk. As you can see, a Limited Partnership can quickly become more complicated from an administrative standpoint, but has many benefits, including no double taxation, and elimination of the unlimited liability risk for limited partners.
Establishing a corporation involves the formation of a separate legal entity under the laws of a particular state. A certificate of formation (formally articles of incorporation) is normally filed with the Secretary of State’s office. In addition, annual reports and other technical requirements are generally needed. There are corporate service firms, which can help with these filings. Additional corporate formalities include the need for a board of directors, corporate officers and an annual meeting of stockholders and directors. The corporate form also faces the possibility of double taxation if corporate income is distributed to business owners as dividends, which are considered personal income.
In addition, all owners have limited liability so long as the appropriate corporate formalities are observed. In general, it is easier to have many owners in a corporation than other business forms.
An S Corporation is very similar to a regular corporation, except it has elected to be treated under the rules of Subchapter S of the Internal Revenue Code. So long as the technical requirements of the Code are met, an S corporation is not taxed at the entity level, and thus does not suffer from double taxation. Adhering to all of the requirements of the Code can, among other things, limit the types and number of owners of an S corporation. Your company is limited to less than 35 shareholders, and no corporation can be a shareholder, only individuals. Each shareholder receives a K1, like a partnership, and may take his/her prorated share of the profits or losses against his/her personal taxes. An s corp. may change to a c corp., which is often the case when a corporation transitions from a startup to a profitable company, even though it may not be a cash-positive business.
Limited Liability Company (LLC)
In 1995, a new form of business ownership has come into being, which for the most part, takes the best of all worlds. The Limited Liability Company (LLC) provides all of its owners with limited liability, and avoids double taxation. In addition, unlike an S corp. there are few, if any, restrictions on ownership. Usually, a document must be filed with the state of formation, but other administrative formalities are generally less involved than with a corporation. The biggest reservation some advisors have about an LLC is that since it is a new business form, some states are still in the process of developing their regulations, and the IRS may still have further pronouncements in the area. Although LLCs have been around for some time, investors are still uncertain about this corporate structure.
For more information about business structures, visit the IRS.