Entrepreneurship

Choosing The Best Structure For Your Startup

Read more at www.forbes.com

By Richard Harroch

Many startup businesses are started as one of three business entities: a Limited Liability Company (LLC), an S corporation, or a C corporation. So how do they differ, and which is the best startup structure? In this article, I explain the differences between these three business structures and highlight the pros and cons of each.

S corporations

What is an S corporation?

An S corporation is a legal entity used to form and operate a business, and which offers the benefit of “pass through” taxation.

How is an S corporation formed?

Either an “Articles of Incorporation” or “Certificate of Incorporation” form is filed with the Secretary of State in the state you decide to incorporate with.

Key considerations for S corporations:

  • Liability protection: If legal formalities are observed, the shareholders are not personally liable for the debts or liabilities of the business.
  • Owners: The owners of an S corporation are “shareholders” or “stockholders” (as opposed to owners of an LLC, who are referred to as “members”) and are issued stock to evidence their ownership interest in the corporation.
  • Taxation: If you properly make an “S” tax election on IRS Form 2553, the profits of the business are only taxed once at the shareholder level.
  • Governance: An S corporation must have a Board of Directors, which oversees and governs the corporation. If there is only one shareholder, only one Board member is required.
  • Filing fees: A fee needs to be paid with the Secretary of State to incorporate.
  • Shareholders: S corporations can have a maximum of 100 shareholders and they must all be U.S. citizens or residents. No corporations or partnerships are allowed as shareholders.
  • Minimum annual franchise tax: Many states require a minimum annual franchise tax of $800. Check your state’s requirements.
  • Classes of stock: S corporation shareholders can only own common stock. Multiple classes of stock are not allowed.
  • Officers: Most states require the S corporation to have a CEO or President, a Secretary, and a CFO. The same person can hold all offices.
  • Corporate formalities: Contracts should be signed in the name of the corporation such “ABC, Inc., by Joe Smith, CEO.” Minutes should be kept of any Board or shareholder meetings.
  • Employee ID: A federal and state employee ID should be obtained.
  • Bank accounts: Any bank or checking account should be set up in the name of the corporation. Personal bank accounts of the shareholders should not be used to pay corporate obligations.
  • Issuing stock: Any stock issued should be in compliance with securities laws. Usually a private placement exemption is available.

C Corporations

What is a C corporation? C corporation is a legal entity used to form and operate a business.

How is a C corporation formed? Either “Articles of Incorporation” or “Certificate of Incorporation” is filed with the Secretary of State in the state you decide to incorporate with.

Key considerations for C corporations:

  • Liability protection: If legal formalities are observed, the shareholders are not personally liable for the debts or liabilities of the business.
  • Owners: The owners of a C corporation are “shareholders” or “stockholders” and are issued stock to evidence their ownership interest in the corporation.
  • Taxation: Any profits of the corporation are taxed at the corporate level. Any dividends made to shareholders are also taxed. This is sometimes referred to as “double taxation.” Note the S corporations and LLCs are generally only taxed at the owner level because of “pass through” taxation.
  • Governance: A C corporation must have a Board of Directors, which oversees and governs the corporation. If there is only one shareholder, only one Board member is required. The bylaws set forth various rules and procedures governing the corporation.
  • Filing fees: A fee needs to be paid with the Secretary of State to incorporate.
  • Shareholders: There is no limit on the member of shareholders in a C corporation, and individuals, corporations, and partnerships can be shareholders.
  • Minimum annual franchise tax: Many states require a minimum annual franchise tax of $800.
  • Classes: C corporations can issue multiple classes of stock. In venture capital-backed companies, founders typically hold common stock and venture capitalists hold preferred stock.
  • Officers: Most states require C corporations to have a CEO or President, a Secretary, and a CFO. The same person can hold all the offices.
  • Employee ID: A federal and state employee ID should be obtained.
  • Corporate bank accounts: Any bank or checking account should be set up in the name of the corporation. Personal bank accounts of the shareholders should not be used to pay corporate obligations.
  • Issuing stock: Any stock issued by a C corporation should be in compliance with securities laws. Usually a private placement exemption is available.

LLCs

What is an LLC?

An LLC is a legal entity used to form and operate a business. LLCs are formed under a state law and have the benefits of liability protection for the owners of the LLC and favorable “pass through” tax treatment.

How is an LLC formed?

An LLC is formed by filing an “Articles of Organization” with the Secretary of State in the state you decide to file with.

Key considerations for LLCs:

  • Liability protection: The owners of the LLC are generally not personally liable for the debts or liabilities of the business.
  • Owners: The owners of an LLC are “members” and are issued “membership interests” to evidence their ownership interest in the LLC. Member interests are analogous to stock in corporations.
  • Taxation: LLCs can elect to have “pass through” taxation so any tax on profits of the business is only taxed at the member level, not the LLC level.
  • Governance: The LLC can be managed by a Managing Member of a Board of Managers. The LLC “Operating Agreement” sets forth various rules and procedures governing the LLC, similar to the bylaws in a corporation.
  • Filing fees: A fee needs to be paid with the Secretary of State to form an LLC.
  • Members of the LLC: There is no limit to the number of members in an LLC.
  • Minimum annual franchise tax: Many states require a minimum annual franchise tax of $800.
  • Classes of interests: LLCs can have multiple classes of LLC member interests, including common and preferred interests.
  • Officers: LLCs can have officers or “Managing Members” who are authorized to run the day-to-day business of the LLC
  • LLC formalities: Contracts should be signed in the name of the LLC, such as “ABC, LLC, by Linda Smith, Managing Member.” Minutes should be kept of any meetings.
  • Employee ID: A federal and state employee ID should be obtained.
  • Bank accounts: Any bank or checking account should be set up in the name of the LLC. Personal bank accounts of the members should not be used to pay obligations of the LLC.
  • Issuing membership interests: Any membership interests issued by the LLC should be made in compliance with securities laws. Usually a private placement exemption is available.
  • K-1s: LLCs are required to issue IRS K-1 forms annually to their members, showing the amount of pass through income or loss. This usually results in additional tax accountant fees.

Frequently Asked Questions About Choosing LLCs vs Corporations

1. In which state should I incorporate or organize my LLC? In most instances, it’s easier and cheaper to incorporate or organize your LLC in the state where the business will conduct operations. If venture capital investors will be involved, they may prefer Delaware.

2. Will venture capital investors invest in an LLC? This is highly unlikely. VCs prefer investing in preferred stock in a C corporation.

3. If I start my business as an S corporation, can I easily convert it to a C corporation? Yes.

4. If I start my business as an LLC, can I easily convert it to a corporation? There will be some costs and complications, but it can be done.

5. Can I adopt a stock option plan for employees and advisors? Stock option plans for corporations are easy to draft and adopt. Stock option plans for LLCs are more complicated.

6. What do bylaws of a corporation typically contain? The bylaws of a corporation contain the rules and procedures that govern the rights and powers of shareholders, directors, and officers. Most lawyers have a prepared standard set of template bylaws that may be modified to meet your company’s specific requirements.

The bylaws cover the following:

  • The size of the Board of Directors
  • When and how board meetings are called (including notice)
  • When and how shareholder meetings are called (including notice)
  • Duties and responsibilities of directors and officers
  • Procedures for exercising voting rights
  • Procedures for the transfer of corporate stock
  • Indemnification obligation for officers, directors, and agents (indemnification refers to protection from lawsuits and claims)
  • The company’s fiscal year
  • General corporate matters

Bylaws generally may be adopted, amended, or repealed by the Board of Directors or by a vote of the shareholders, and the bylaws may limit the Board’s powers in this respect.

7. What does an LLC Operating Agreement typically contain? The LLC Operating Agreement sets forth the owners’ financial, management, and other rights and responsibilities. Here are some key issues that should be addressed in the LLC Operating Agreement:

  • What amount of capital contributions are made to the LLC by the parties, and when those contributions are required to be made
  • Any penalties or remedies if the capital contributions are not made
  • How profits and losses are to split and distributed among the owners
  • Whether any members or class of securities of the LLC have preferences in distributions or on liquidation (akin to “preferred stock” in a corporation)
  • Who will manage the LLC (a sole manager, a group of managers, or all of the members)
  • How any officers will be appointed
  • Voting rights for major events like additional capital contributions or sale of the business
  • Indemnification protection for the managers running the business
  • Restrictions on transfer of LLC interests (the LLC interests are often referred to as “units”)
  • Procedures for meetings of the members
  • Procedures for dissolution

Most lawyers or online filing services have a standard from of LLC Operating Agreement that you can tailor to your individual situation.

8. Can an LLC or corporation be set up online? Yes. Once you have decided on the best startup structure for your business, there are a number of online services such as CorpNet.comMyCorporation.com, and LegalZoom.com that will set up your LLC or corporation for a fee.

Related articles on AllBusiness.com:

Copyright © by Richard D. Harroch. All Rights Reserved.

About the Author

Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a venture capital fund in the San Francisco area. See all his articles and full bio on AllBusiness.com.

This article was originally published on AllBusiness.com.

Read more at www.forbes.com

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