Entity Selection: Make Your Dreams Come True
Do you want to quit your job? Start a business? Follow your dreams? Start a side hustle for some extra cash? Or just get some tax breaks for your hobby?
If any of these sound like you, then this post is for you! In this post, we are going to discuss a few of the questions an individual should consider before embarking on their entrepreneurial journey. While you can start a business by selecting any entity, not every entity is right for you, and choosing the right entity at the outset can help you avoid costly mistakes or corrections down the road. This post will briefly discuss Sole Proprietorships, Partnerships, Limited Liability Companies, and Corporations.
Sole Proprietorships
A Sole Proprietorship is the simplest entity. If you want to have a “business” without jumping through legal hoops, the Sole Proprietorship is quick, easy, and might be right for you. Sole Proprietorships are simple to start, generally requiring minimal paperwork filings. With proper documentation, a Sole Proprietorship can have tax benefits similar to other business entities in the sense that costs/expenses can be utilized to offset revenue of the Sole Proprietorship - but please document your transactions well, get a separate tax ID, set up a separate bank account, etc., and discuss matters with a tax specialist!
Unfortunately, a Sole Proprietorship does not carry limited liability protections that other entities carry. Meaning that if your Sole Proprietorship becomes subject to liability, the debts and obligations of the business may be passed along to you and your assets in your personal capacity - which is a primary concern for most business owners!
Partnerships
There are two primary types of Partnerships; General Partnerships and Limited Partnerships. This section will discuss each briefly, but for more information, please reach out to us!
General Partnership
Similar to a Sole Proprietorship, a General Partnership is incredibly simple to start. It is simply the association between two or more persons for a common business venture. A written agreement to form a General Partnership is recommended (strongly) but not required. Also, similar to a Sole Proprietorship, the Partners are taxed via pass through method. Meaning that the Partnership itself is not taxed in addition to the Partners. The tax burden is “passed through” to the individuals depending on their “ownership” or “economic interest” in the Partnership.
Also similar to a Sole Proprietorship, the General Partnership does provide limited liability for the Partners. Meaning that each Partner my be fully personally liable for the debts, obligations, i.e. liabilities of the Partnership. This tends to make General Partnerships unappealing to potential Partners as well as investors and/or potential buyers of a company.
Limited Partnership
In contrast, a Limited Partnership requires a few extra steps for founders/partners. A Limited Partnership is a Partnership in which duties and obligations of the company are divided between “General Partners” and “Limited Partners”. States tend to have different rules and regulations of Limited Partnerships, so please do your homework and talk to a professional in your state.
While a Limited Partnership differs considerably from a General Partnership (mostly in liability), the tax treatment of Limited Partnerships looks similar to that of a Sole Proprietorship or General Partnership in the sense that tax burdens are allocated proportionally to Partners (passed through), but the Partnership is not taxed as a separate entity.
The primary difference between a General Partnership and Limited Partnership is the “limited” liability that accompanies a Limited Partnership. While Limited Partnerships generally require additional paperwork to realize the limited liability, Partnerships that do jump through the requisite hoops are able to shield “limited” Partners from some liabilities of the Partnership that were not a result of the Limited Partners actions. Again, each state has different rules, regulations, and laws, so please consult an attorney in your state for a full discussion of the liabilities that may be escaped in a Limited Partnership.
Limited Liability Company
Limited Liability Companies or LLCs are probably the most popular entity for entrepreneurs as they begin to chase their dream. Like you might have guessed, an LLC limits your liability and the liability of other potential Members! And while LLCs can be a great option for some, they may not be perfect for all. While this post will discuss a characteristics of LLCs, again, you should consult with a professional rather than relying on this post for all your LLC legal information.
Unlike a Sole Proprietorship or General Partnership, an LLC does have filing requirements generally with your Secretary of State. Additionally, these filings aren’t exactly cheap. Some states, like Tennessee, can cost a few hundred dollars (plus expedited charges). In addition to what is filed, every LLC should also have an Operating Agreement. This document provides some details about the entity. If it is multimember, this is where membership interests, economic interests, along with countless corporate formalities will be laid out. While you can get a copy from most E-Legal service companies, I would strongly encourage you to work with an attorney (especially if you are a multi-member LLC). On that note, Members of an LLC may be individuals and/or companies, and the number of Members is entirely decided by you (a Member).
A great thing to remember about LLCs is that they provide a lot of flexibility. Members may have Membership Interests, Voting Rights, or Economic Interests, and these varying rights and interests can also be divided up in almost any creative way that you can imagine. It would not be uncommon for you to own a 50/50 Membership interest with your fellow Member, but for one of you to hold a 60% Economic Interest (meaning you get more money from the business than the other Member). Additionally, it has become more and more common for LLCs to use a “Profit-Share” method to incentivize persons within the company or to attract talent. The realistic truth is that LLCs can be wildly creative, which has garnered them the reputation as the “Wild West” of entity selection.
However, a downside (traditionally) to LLCs is that they can be messy and equity grants, advisor shares, stock options, etc., are a little less straight forward than they might be with a standard Corporation. This not only can create more in legal fees, but traditionally has resulted in reduced excitement from investors. However, the growing popularity of LLCs and the increase in investment capital is trending away from this traditional norm. And remember, you can always convert an LLC to a Corporation down the road if an LLC makes more sense for the short term, but a Corporation makes more sense in the future.
Corporations
For now, we will focus on the standard C-Corporation. While S-Corporations have a place in this discussion (and so do non-profits and B-Corps), we’re going to focus on the classic C-Corporation. It sounds intimidating to many, but could be your best option depending on you and your company’s vision. Corporations carry the benefit of limited liability but also the burden of corporate formality hoops (similar to an LLC).
Unlike many of the entities discussed in this post, a C-Corp does not have pass through taxation principles. The Corporation and its owners are entirely separate as far as the tax code is concerned. While the money paid out to owners may be registered as an expense or something of that nature that may generate tax benefits, the Corporation and the individual/owner each have a tax burden. But, this is not necessarily a bad thing (Corporate taxes may be better than individual taxes) - Again, it is of the utmost importance that you consult with a professional (Attorney or CPA or Tax Specialist) about your particular case.
Similar to an LLC, Corporations can get creative with “ownership” structures. Many Corporations have multiple classes of stock and multiple series within those classes. For example, if you were to hire a new employee to your Corporation, you might want to offer them an “equity incentive” that might look something like…Class B Common Stock…and that stock might have a 4-year vesting schedule with a 50% cliff at 2 years subject to double-trigger acceleration. Or, you might offer an investor Preferred Shares in exchange for $500,000.
And, as noted above, an investor might be more likely to invest in a Corporation than an LLC because those Preferred Shares look like what they are used to seeing, which is why investors have traditionally preferred Corporations to LLCs.
The Wrap Up
I hope this Post has been educational. While most of it merely scratches the surface of entity pros and cons, my hope is that it sheds light on the fact that you do have choices. Not every business venture has to be a “Delaware C-Corp” and not every hobby should be a Sole Proprietorship. And lastly, your entity selection today is not set in stone. If you chose to be an LLC but now you’re thinking that you want greater simplicity in issuing equity grants without reducing your likelihood of future venture capital investments, you can make changes to your corporate structure. A good attorney will be able to walk you through the required steps while discussing the pros and cons of these strategic decisions to help you avoid costly mistakes.
If this Post has helped you and you’d like to learn more, Williams Law is here for you, so don’t hesitate to reach out at Info@trentwilliamslaw.com. And tune in for the next post in the Williams Law Startup Series for further discussion of those Equity Incentives I mentioned earlier.
