Entity Selection Simplified

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When starting a business, one of the first decisions you’ll need to make is what form of business entity to establish.  There’s lots of information on the Web re: the advantages and disadvantages of each entity type but, to my knowledge, nothing in the way of a methodology to help the reader actually make a decision.  So what follows is a simple algorithm to help you decide whether you should be a C corporation, S corporation, limited liability company, general partnership or sole proprietor.

Question #1: Will you be seeking venture capital funding?  If yes, you’ll want to be a C CORPORATION.  If no, go to Question #2.

Question #2: Will you be relying on options or equity to attract and retain employees and contractors?  If yes, you will want to be a CORPORATION and go to Question #3.  If no, go to Question #4.

Question #3: Do you want pass-through tax treatment?  If yes, you’ll want to be an S CORPORATION.  If no, you’ll want to be a C CORPORATION.  Caveat: S Corporations have several restrictions, such as (a) shareholders cannot be a corporation, a partnership or a non-resident alien, (b) there cannot be more than 100 shareholders, and (c) there cannot be more than one class of stock.

Question #4: Will you be seeking outside capital from any sources, or are you willing to pay approx. $2000 upfront and $800 annually (if you’re doing business in California) to achieve limited liability?  If yes, you will want to be a LIMITED LIABILITY COMPANY.  If no, go to Question #5.

Question #5: Are you going into business with others?  If yes, you’ll want to be a GENERAL PARTNERSHIP.  If no, you’ll want to be a SOLE PROPRIETORSHIP.

Rationale behind Question #1: VCs typically will only invest in C Corporations, because pass-through entities may produce unrelated business income that the tax-exempt limited partners of a VC fund do not want.

Rationale behind Question #2: Granting “profits interests” in LLCs is more complicated, and less understood by recipients, than granting options in corporations.

Rationale behind Question #3: S Corporations are taxed like partnerships i.e. only at the shareholder level.  So an S Corporation is particularly advantageous when (a) the corporation will be incurring losses and the shareholders have other income against which the losses can be deducted, or (b) the corporation will be paying dividends because it is generating (and not reinvesting) cash in excess of the cash compensation that will be paid to management.

Rationales behind Question #4: Investors typically want limited liability, so won’t invest in general partnerships or sole proprietorships.  LLCs are a great way to achieve limited liability without having to comply with corporate formalities, but have setup costs and, in California, are subject to an annual franchise tax of at least $800.

Like other discussions of the law that you’ll see on the Web, this one comes with the caveat that it consists of general principles only, and that there may be facts particular to your situation that would cause you to reach a different conclusion.  Nevertheless, you can use it as a first cut, and then refine your analysis to take into consideration additional factors.

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