One of the first hurdles an entrepreneur has to clear when starting a business is which entity type to choose when registering her business. There are many forms to choose from with different tax implications and different levels of liability. The three key considerations when making this decision are limited liability for the owners, ownership and management rights and the tax treatment of the entity. While there are plenty of choices corporations and limited liability companies are the most common vehicles for startups. Corporations are the most frequently used formation vehicles, especially by companies seeking venture financing. LLCs are pass-through entities that are not subject to separate level of tax and can provide founders with great flexibility when it comes to governance issues. On the other hand, LLCs are often more complex, which means higher initial costs, and certain venture capital funds are hesitant to invest in LLCs because of tax considerations and the aforementioned complexity. The other popular option is the Subchapter S Corporation, which can offer pass through tax treatment for its owners like an LLC if certain requirements are met. Below is a further outline of some key differences and considerations for each of these entities.
What are some key post-incorporation issues to consider?
After your entity is formed it is important to execute and receive confidentiality and intellectual property assignment agreement from all employees and service providers.
File to obtain a federal employer identification number. Information can be found on the IRS website and filing of a form SS-4 and this filing can be done online.
File to obtain the state level identification numbers or other state level requirements such as workers’ compensation. Additionally, federal and state securities laws may require governmental filings reflecting the issuance of stock to founders. Whenever you issue any form of security (debt or equity) you will want to ensure that you comply with the Securities Act of 1933. For example, Rule 506 under the 1933 Act provides a commonly used exemption when issuing unregistered securities. Under the rule, there is no limit on the number of investors permitted so long as all investors in a given offering are accredited investors. Rule 506 requires no disclosures for an unregistered offering with the exception of required compliance with anti-fraud rules. Please consult your legal counsel regarding compliance with this and other rules when issuing stock in your newly-formed corporation.
Obtain foreign state qualifications. Corporations must qualify in states (other than the one in which they are incorporated) if they transact business in that state. Using a registered agent service can facilitate this process.
In the case of a C Corporation you should also do the following:
Issue shares of common stock to company founders. In association with this you should collect the subscription letters and founder stock restriction agreements from founders.
Collect the purchase price for shares issued to each founder and have this reflected in the company’s records.
Print each stock certificate given to company shareholders and have it signed and dated by the President and Secretary of the Company. Whether to retain or deliver the Stock Certificate will depend upon the legal implications of your Founder Stock Restriction Agreement.
Prepare a stock ledger. This should include share amount, name of recipient and consideration paid for the shares. The stock ledger should also include any transfers or cancellations of shares.
In addition, when filing a C Corporation it is important to have all your required documents filed with the state and maintained internally. The following is snapshot of some required C Corporation documents.
1. Certificate of Incorporation: This document sets forth the Company’s initial authorized capitalization and other pertinent details about the corporation. Information commonly included: name of corporation, number of shares to be issued, and jurisdiction of incorporation.
2. Bylaws: The Bylaws provide the procedural mechanics required by state law, including establishing the number of authorized directors.
3. Action by Written Consent of Incorporator: This document appoints the initial Board of Directors and adopts the Bylaws of the Company.
4. Initial Organizational Resolutions of the Board of Directors: This document completes the organization of the Company by appointing the Officers and authorizing the issuance of shares to the Stockholders, among other things.
How does the Tax treatment differ with an LLC, S Corp or C Corp?
1. C Corp
Double Taxation. A C Corp is subject to double taxation, meaning earnings are taxed at the entity level and again when they are paid out to the company’s shareholders. For example, if a C Corp has earnings of $10 the company will need to pay tax on that amount. If it later declares a dividend to shareholders and pays out all $10 the shareholders will need to pay tax on that, too, resulting in the $10 earnings being taxed twice.
No Tax-Free Exit. In a C Corp gain is also recognized on liquidating distributions, so generally there is no tax-free way to get assets out of a C corporation (there are, however, some exceptions for parent corporations of liquidating subsidiaries).
Net Operating Losses Carryover. A C Corp can carry over losses in excess of income to reduce income (and therefore tax) in the two preceding taxable years and the 20 taxable years following the taxable year of loss. Note, however, that the use of net operating losses is limited after certain changes in ownership.
Debt Financing. A C Corp may deduct interest payments on debt financing, subject to certain limitations. The IRS may, however, attempt to re-characterize a company’s debt as equity, thereby causing deductible interest to be re-classified as a non-deductible dividend.
Limited Liability. As with most incorporated entities, shareholders of a C Corp enjoy limited liability.
Flow-through tax treatment. The flow-through tax treatment of an LLC means that members, not the entity itself, are subject to tax, so only one level of tax imposed unlike with a C Corp. This is sometimes seen as one of the key benefits of an LLC, especially for entities that are either not seeking venture financing or will not seek venture financing for a long time.
Flexibility. The LLC allows for more flexibility in how allocations and distributions can be apportioned among owners. Unlike an S Corporation, there is no limit on the number of members of an LLC. LLC’s have flexible ownership, the ability to issue several classes of stock, and the choice to personally manage the company or to elect a management group. Unlike corporations where the economic split among owners and investors is most often based on the share ownership of the interested parties (subject to any special rights of the preferred stock, such as associated dividends or liquidation preferences), in LLCs the economic split may be based on unit ownership or some other metric, e.g., it is sometimes possible to designate that a certain class or series of units is entitled to a certain fixed percentage of the economics, regardless of the number of units of that class or series that are outstanding. This makes the LLC an attractive vehicle for some more complex economic arrangements such as “catch up” or “claw back” clauses. However, given the complexity of these issues it is important to note that there can be tax pitfalls in structuring these arrangements, so a tax advisor or experienced attorney should always be consulted.
Limited liability. As its name suggests, the LLC offers its owners limited liability.
3. S Corporation
Shareholder limitations. An S Corp limited to 100 shareholders and this is limited to natural persons and certain trusts. They are also limited to offering shareholders only one class of stock and cannot have shareholders who are non-resident aliens.
Flow-through. The S Corp is treated like LLCs – no tax at the corporation level, and corporation’s income, credits, gains and losses flow through to shareholders.
Shareholder Flow-through deductions. Shareholder loss deductions are limited to the aggregate tax basis of (i) the shareholder’s S Corp. stock and (ii) the debt of the S Corp. to shareholder.
Borrowing. Stock basis is not increased by corporate borrowing, even if the shareholder guarantees debt; to increase basis and take losses, shareholder must borrow directly and contribute cash (or other property).
Property distributions. If the S Corp. has earnings and profits from when it was a C Corp., property distributions will generate gain recognition.
No special allocations. All income and loss is shared in proportion to stock ownership.
Venture capital termination. Venture capital investment usually terminates S Corp. status because venture capital preferred stock violates rules against multiple classes of stock and VCs are disqualified shareholders
How is the contribution of property to an entity treated for tax purposes?
As a general rule when a shareholder contributes property to an entity in exchange for new property that is a taxable event. For example, if the shareholder contributes a patent to the company in return for shares that will be considered a taxable event and the tax basis will be the difference in value of the contributed property versus the fair market value of the stock received. However, corporate founders (and other contributors) recognize no gain or loss when they transfer property to a newly-formed corporation or LLC in exchange for its stock if (i) founders receive only stock of the new company; (ii) anything received in addition to stock is taxed as “boot” and gain may be recognized to the extent of boot received; and (iii) founders, immediately after transfer, are members of a group “in control” of the new company, which is defined as 80% of the combined voting power of all classes of stock entitled to vote and 80% of each nonvoting class. If these requirements are met, then the transfer of property results in non-recognition treatment.
Any other general rules to consider?
It is vital that you keep good records for your entity no matter whether you choose to register as an S Corp, a C Corp or an LLC. Good corporate governance practices at the inception of the company will increase the likelihood of the success of the company, decrease the occurrence of legal and regulatory problems, and facilitate future financing efforts. As you enter into material agreements such as share purchase agreements or share transfer agreements be sure to have copies of each of these agreements within your records. These agreements can also include IP licenses, office leases, any agreements with suppliers, vendors and customers or any other agreements that may have a material impact on the company’s ability to conduct business.
When starting a company you have a lot of decisions to make about liability, taxes, capitalization, and governance. Lawyers, financial advisors, and accountants are going to be key assets when it comes to making these decisions. Keeping good records, complying with state and federal regulations, and planning for long term financing are essential to the success of the company and having the right people around you can aid in this process.
For more information on any of the topics covered in this article please contact one of our attorneys at email@example.com or visit our website at www.rbernardllp.com to learn more about our practice. Research and writing assistance for this article was provided by Rachel Gholston. Follow us on Twitter.