How Choosing Your Company Legal Structure Affects Business Down the Line

Expert Advice to Help You Decide Among Different Types of Business Entities

When you start a new business, you face critical legal and practical decisions that affect everything—including the likelihood of succeeding—throughout your business’s lifetime. Decisions about the company legal structure raise questions that affect your company’s future. For example:

• Will you organize a corporation or limited liability company (or something else)?
• Should you organize in your home state or a “commerce-friendly” state, such as Delaware?
• How do your plans for raising capital affect entity choice?

We consulted professional advisors and entrepreneurs about early formation issues and the differences among different types of business entities:

• Peter Feinberg, Partner at Hoge Fenton
• Jon Friedland, Partner at Sugar Felsenthal Grais & Hammer
• Steve Gillette, Partner at Jones Day
• Michele Berdinis, President at Beeline Legal Services

Do You Need a Legal Entity When You Start a New Business?

Forming a legal business entity can help you:

• Limit your personal liability for the debts of your business.
• Transfer ownership of your firm in the future.
• Ensure continuity of your business’s existence.
• Build credibility with customers and third parties.
• Structure management and control with flexibility.

Friedland states, “Forming a legal entity, if for no other reason than to shield one’s personal assets from being at wholesale risk for the liabilities of one’s business, is critical. The question in nearly every case is not if an entity should be formed, but what type of entity should be formed.”

Types of Business Entities: C Corp, S Corp, LLC

Differences Between Corporations and LLCs

Corporations and limited liability companies are the most common types of businesses. You can form either type by filing documents with the Secretary of State (or some other state office).

Once formed, the government taxes your corporation as a “C corporation.” However, if you file an election with the IRS (and, maybe, your state tax office), you may pay as an “S corporation.”

Berdinis states, “There are lots of factors that go into deciding what type of entity to form: How many owners are there? Will employees get equity incentives? Are you raising capital from professional investors? Could the business operate at a profit for a while or just be grown fast and sold? Each of these can affect the decision of what to form and where to form it.”

C Corporation

A C corporation can have any type of shareholder (people or other entities) and different types and classes of stock. The C corporation pays corporate tax rates, and shareholders pay taxes on dividends they receive.

This double tax sounds bad, and under the right circumstances, it can be a pain. However, many corporations never pay dividends. Instead, they might put all their profits back into growth, so the “double taxation” may be more theory than reality.

S Corporation

Like partnerships, S corporations offer a single level of taxation. Income and deductions pass through to the corporation’s shareholders. All the shareholders have to be people (and not other entities) and must be legally in the United States.

Examples of Other Entity Choices

Professional Corporations

Professional corporations are designed for specific professional service providers, such as lawyers, doctors and accountants.

Non-Profit Organizations

NPOs are an entirely different type of an organization that intend to serve a non-profit purpose. This is not suitable for a business you hope to sell someday.

Limited Liability Company (LLC)

A limited liability company, or LLC, offers more flexibility than a corporation. As with owners of partnerships or sole proprietorships, LLC owners report profits or losses on their personal income tax returns. The IRS does not treat an LLC as a separate entity.

Another advantage of this company legal structure: the parties to an LLC operating agreement (the document that governs the rights and obligations of the owners of the LLC) are much more free to contract as they like as compared to the shareholders of a corporation are in a shareholders’ agreement.

For example, LLCs may select any form of profit distribution, which does not have to be in the ratio of the ownership between different members.

Moreover, LLCs do not have a legal requirement to conduct formal meetings, maintain minutes of the meeting or record resolutions.

LLCs are, historically speaking, new; the first LLC in the United States was a Wyoming-based oil company in 1977.

There are two situations in which an LLC is ideal over other types of business entities:

• A business with only one owner. An LLC with one owner is a “disregarded entity” for tax purposes. It still limits your liability, but it does not pay taxes or even file an informational tax return (unlike a partnership or S corporation.)
• A business with multiple owners who want to pass through taxation, but can’t meet the requirements for being an S corporation.

Most professional investors don’t want to invest in LLCs, but that may change.

Regulatory Formalities

Each state has its laws and rules that describe the first steps to form and maintain an LLC or corporation. The documents are not especially complicated, and you won’t require an attorney’s services to file them.

However, even very small businesses may prefer to hire an attorney for work related to forming and maintaining the existence of an entity:

Filing the appropriate documents with your secretary of state comes first, but you’ll need to complete many other steps and documents after filing with the secretary of state:

• Bylaws
• Action of incorporator
• Action of directors
• Operating agreement
• Shareholder agreement
• Buy/sell agreement

At some point, you’re probably going to need an attorney for the following:

• Draft your customer agreement
• Review your lease
• Help protect your intellectual property
• Resolve an employment issue
• Assist with getting a required license
• Help with the documents and filings for raising capital

All of that will be easier if you have a pre-existing relationship with an attorney who already knows your business.

In this regard, keep in mind that the formalities required by a state to create and then maintain a legal entity are not necessarily the only legal requirements your business must fulfill.

Many businesses, for example, require special licensing. Moreover, the term  “corporate formalities” encompasses much more than merely the legal requirements to operate in a state.

If your company is a Delaware corporation, for example, it must have a board of directors (this is true in most or all states). Delaware law requires that the business and affairs of every corporation must be managed or supervised by a board of directors.

Regardless of Company Legal Structure, Maintain Separate Finances

Beyond this, you should maintain a company’s finances separately from those of its owner(s). When a single person owns a company, the need to maintain such separateness may be counterintuitive. Fail to do so, and you may become liable for all of the obligations of the company.

Consult with a trustworthy and knowledgeable advisor, like an attorney or accountant. This is the “ounce of prevention” that’s “worth a pound of cure.”

The cost of fixing something that was done wrong is much greater than the cost of doing things correctly the first time.

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[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: The Very Basics – Forming the Business and Overview of General Corporate Law Compliance. This is an updated version of an article originally published on February 27, 2017.]

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