A variety of factors influence the selection of a business entity and each business’ situation is different. The following are some of the most common considerations. However, every situation is unique and you should contact a business attorney to help evaluate your situation.
Tax Treatment
A business entity may be treated in one of two ways for tax purposes: it may pass profits or losses through to its owners who claim these on their individual income taxes, or the entity may have to pay its own income taxes.
Many owners of small businesses want pass-through treatment and so this has led to the proliferation of the LLC taxed as a partnership. General partnerships and limited partnerships are also treated as pass-through entities. A corporation, if it meets certain requirements, can receive pass-through treatment as an S-corp.
But pass-through taxation can result in unintended consequences. An owner is attributed the income of the pass-through entity even if the business doesn’t distributed any of that income. Known as “phantom income”, this can leave an owner holding the bag for a large tax bill without receiving money out of the business. Business owners can work with an attorney and CPA to prepare operational documents that address this problem.
Ongoing taxes aren’t the only concern either. For example, only corporation stock can qualify for preferential capital gains treatment as “qualified small business stock” (“QSBS”). Owners who hope to take advantage of this treatment as part of a future sale may want to organize as a corporation. A business that expects to undertake an initial public offering may also be better suited as a corporation, as doing so often requires conversion to a corporation at a later date if another entity is used when the business starts. Again, business owners should consult their attorney and CPA or tax advisor about how this impacts choice of business structure.
Flexibility/Formality
The operational reality of a business can influence the choice of entity. Early-stage companies that require a high degree of flexibility are often better suited to LLCs, because they can function under operating agreements which give the key individuals wide latitude to make business decisions. This may streamline operations compared to a corporation structure, which requires several layers of authorization to make company actions legally binding. An LLC structure is also well-suited to personal businesses due to this flexibility.
On the other hand, a business with a larger number of individuals involved may prefer the more structured approach of a corporation. This is often the case where passive investors or minority stakeholders want a level of control over the active managers of the business, which is more easily found in a corporation than an LLC. Businesses that intend to provide significant equity compensation may also be better suited to corporations due to established structures and tax treatment for stock options and other forms of incentive equity awards.
Active and Passive Owners
A significant question is whether all of the business owners will be active in the operation of the business. If there are passive owners, then the entity structure may need to be configured to address their role. It may not make sense to have a business where the passive owners still have full control and responsibility. Passive owners are often better set up as limited partners in a limited partnership or as shareholders in a corporation. The active owners may be the general partners in a limited partnership or shareholders and directors in a corporation. An LLC can also be structured with different classes of ownership interests—one for passive owners and one for active owners—with different rights and obligations set out in the operating agreement.
External Investment
For companies that intend to self-fund, any entity form is workable. Companies that only need to raise initial funding from an external source can often rely on either the limited partnership, LLC, or corporation. Similarly, if a company intends to finance primarily through debt, many lenders will be fine with an LLC or a corporation, though individual lender practices vary.
However, businesses that intend to raise one or more rounds of external equity funding, such as venture-backed tech companies, must often organize as or convert to a corporation. This is because institutional investors generally require their investment targets to be organized as Delaware corporations for the predictability of structure and shareholder rights compared to LLCs or partnerships. Though this informal industry standard is not absolute, it is something business owners should work through with their counsel.
