Choosing your entity

By: Kritika Bharadwaj

Several aspects are taken into consideration when forming a company, including the type of entity, and its implication on corporate taxes, individual taxes, corporate compliances and obligations as an employer. This note provides brief pointers on certain considerations in forming your entity. Please consult your legal and tax advisor to determine which form of entity structure would be most suitable for your business needs.

While it is recommended to incorporate your company in the state where most business will be conducted, if you expect to raise capital, then you may consider incorporating in Delaware, which is historically known for ease of business and litigation. Note that if your company engages in business or has employees in a state other than the one where it was formed, then your company may need to qualify to do business in that state as a “foreign” entity. For failing to comply, your company may be subject to late fees and be restricted from bringing law suits in that state.

 Corporations and limited liability companies (LLCs) are the most common choice of entities. Liability is limited in both, and does not pass through to shareholders and directors, unless there is fraud or bad faith conduct. In determining the type of entity to form, specifically in Delaware, you may consider the following:

LLC:

• A one member LLC is considered as a disregarded entity for tax purposes. An LLC with two or more members is taxed as a partnership. There are no restrictions on the types of members who can own the LLC.
• For federal income tax purposes, a multiple-owner LLC is taxed just like a partnership, unless it elects to be taxed as a C-corporation.
• In Delaware, an LLC taxed as a partnership bears minimum franchise taxes even if it has no taxable income.
• The net income is divided between the members, who will pay tax on their personal state tax returns. Consult with your tax advisor to assess your overall net income and individual tax, and then determine if it is preferable to incorporate an LLC.
• An LLC allows flexibility as to how members split their corporate profits and losses.
• An LLC requires less stringent corporate formalities to be observed and maintained.
• Profits interests or non-qualified options (to acquire a membership interest) can be granted to employees, however, incentive stock options (ISOs) are not available.
• The right to receive distributions is transferable, however such transfer may not automatically entitle the transferee to vote or participate in the LLC’s management.
• An LLC is typically converted to C-corporations before an initial public offering.
• An LLC is managed by its members unless the articles contain a statement that it is manager-managed. Members/managers owe the fiduciary duties of loyalty and care to the LLC and the other members, subject to exceptions stated in the operating agreement.

 Corporation:

• The corporation itself is taxed on its income, and then shareholders are taxed upon any dividends received. Shareholders may be able to take advantage of splitting the business income so that part of it is taxable to the corporation and part of it is taxable to the shareholders.
• There is flexibility in the type of shares (for example, common, preferred, convertible debt, phantom) and stock options that can be issued.
• C-corporations and S-corporations shall have officers as set out in the bylaws or determined by the board from time to time. The same person may hold any number of offices.
• Directors owe a fiduciary duty of care and duty of loyalty. Directors are not liable for errors in judgment if they were disinterested and independent, acting in good faith, and reasonably diligent in informing themselves of the facts.

S-corporation:

• Profits and losses pass through the corporation and each shareholder pays income tax on his share in the company’s income.
• Profits of the S-corporation which pass through to the shareholders are not subject to self-employment tax (social security and medicare tax).
• Corporate profits and losses must be divided in proportion to the percentage of shares owned by each shareholder (unlike in LLC).
• S-corporation cannot have shareholders who are non-resident and non-citizens of the United States.
• Shareholders have to be individuals, not LLCs or corporations; there may be a maximum of 100 shareholders.
• S-corporation cannot have different classes of stock but differences in voting rights among shareholders are permitted. Although straight debt instruments are permitted, certain debt instruments, options, warrants, etc. may be treated as a second class of shares.

Although C-corporations may be complicated from an accounting, tax or legal standpoint as compared to LLCs, and as such, may incur fairly high legal and accounting costs, they are usually preferred by investors due to the flexibility in having different classes of stock, with and without preference.  However, one size does not fit all. A suitable business structure depends on your business needs and enables your company’s growth plans. It is therefore important to consult your trusted advisor at the outset.