Entity Structure-Which one is right for your start-up?
By Jeffrey D. Solomon, CPA, CVA
Determining the type of entity a young technology based company should be is perhaps one of the most important business decisions a young founder can make. This decision will have long lasting ramifications and could mean the difference between a successful endeavor and one that is not in the end. There are certain benefits and disadvantages of each type of entity, and depending on 1) who you are and where you want to end up, 2) your investor profile, and 3) the type of technology or company that you are the decision will fall in place.
One of the first issues you need to ponder is what your company’s “end game” is. If you think the company is going to be “bought out” or a merger and acquisition candidate versus an IPO could drive the entity structure decision a certain direction. We generally advise our clients to consider three potential types of structures, all of which afford some form of limited liability protection, but have very different tax implications. These three choices are:
1) the C corporation- a separate legal entity that has both officers and stock. A C corp pays its own tax and allows for different classes of stock to its shareholders. There may be certain tax free benefits that shareholders can take advantage of as well.
2) the S corporation- a corporation much like the C corporation above but does not pay its own tax-has same legal protection as regular C corporation though. Income and losses flow through to shareholders but this entity can only have one class of stock.
3) the LLC- a hybrid of a corporation and a partnership. The LLC has flow through characteristics, but is less formal than a corporation and offers great flexibility in its treatment of owners and flow through income/loss. It is more flexible than an S corporation, and does not have stock certificates but “units” instead.
One of the key advantages of being a flow through type of entity (an LLC or S Corporation) is that in an “asset sale”, there is only one level of tax to be paid, at the shareholder or member level. This means the investors could potentially save being double taxed. In an exit that is structured as a stock deal, this benefit is eliminated.
If you think your angel group or investors will want certain flow through tax benefits, you may consider choosing an LLC or S Corp. We have seen these entities used where the founder induces the investors with the additional benefits of tax write-offs for use on their own personal returns. The LLC, taxed as a partnership, is the vehicle of choice for many today due to its flexibility and ability to pass losses or income directly through to the owners. However, we have seen numerous occasions where the investor group, because it has limited partners, do NOT want the flow through losses. The LLC can be complicated to administer and can lead to additional costs in operating. The LLC affords the benefits of allowing the owners to allocate losses or cash flow, for instance, to a certain group of members, such as preferred series investors. However, the conversion of an LLC to a C corporation down the road later in years could have major tax ramifications.
S corporations are also flow through entities. The downside of the S Corporation is that it has certain limitations such as the type of owners, and that it is limited to only 100 shareholders presently. However, the conversion to C Corporation is usually quite simple and may not result in tax upon the conversion.
Of course, if you see yourself raising a large venture capital round, you may just, from the start, incorporate as a C corporation. This does not allow you the benefits of losses flowing through to the investors or the benefits of one level of tax on an asset sale, but it is the type of entity that larger companies are today. Any losses early on can be carried forward to offset future income. Most venture capitalists seem to push their portfolio companies to this type of entity today. They seem to like to use these as the standard type of investments due to the ability to give different classes of shareholders various types of rights and preferences. The benefit of this type of entity is that it has stock, is its own entity from a tax standpoint, and is easy for investors to work with.
The early C corp. investors also have an added benefit in that if they invest in the qualified small business when the assets are valued at less than $50 million and they hold the stock for at least 5 years, 50% of the gain can be eliminated.
Having a group of knowledgeable advisors, including both lawyers and accountants that specialize in these areas and that spend the time finding out about you, your investors and your aspirations are key to a proper decision being made. The tax and legal issues in these areas are complex, and are only summarized above. Good professionals on your team will help you determine which entity best fits your situation and give you the best opportunity for success.
Jeffrey D. Solomon, CPA, CVA is a partner at the accounting and business consulting firm of Levine, Katz, Nannis + Solomon, P.C. He heads its emerging business technology practice group and can be reached at jsolomon@lknscpa.com.
