One of the first decisions you will have to make when starting a new business is choosing the type of entity that will house the business. From raising capital to paying taxes, the type of entity you choose can help or hinder your growth. Although several types of entities exist in the United States, this post will focus on the three most common entity types: C-corporations, S-corporations, and limited liability companies (LLC).
Key Differences
The key differences between corporations and LLCs typically revolve around governance and taxation. Corporations are the most common form of business entity and feature a well-established body of law, which generally provides greater predictability in litigation outcomes at the expense of a more ridged structure and burdensome governance requirements. LLCs on the other hand, shed many of the ridged formalities that exist for corporations while allowing for greater flexibility in many respects, including governance and taxation.
Here is a summary of key differences among C-corporations, S-corporations and LLCs:
Other Considerations
As you can see, there are some significant differences between C-corporations, S-corporations and LLCs. In addition to the items mentioned in the table above, there are a couple of other points you should be aware of when choosing your entity.
Phantom Income. In an entity, which has pass-through taxation (typically an S-corporation or LLC), profits are allocated to the owners of the entity regardless of whether they actually received any cash distributions from the entity - often referred to as "phantom income." This typically occurs when a business reinvests its profits rather than distributing them to the owners. For example, assume that ACME, LLC, a limited liability company taxed as a general partnership, has two founders who each own 50% of the company. Over the course of the year, ACME, LLC earns a profit of $200,000, of which, $50,000 is distributed to each founder, and $100,000 is reinvested in the company. Despite only receiving $50,000 in cash distributions from the company, each founder will responsible for paying income tax on $100,000.
Investment. Start-ups, which have an eye toward raising venture capital, typically choose to form C-corporations. This is because venture capital firms are most familiar with C-corporations, C-corporations avoid the phantom income issue, and C-corporations are permitted to issue multiple classes of stock, which allows investors to negotiate the terms and preferences of their equity. Additionally, the vast majority of companies listed on U.S. stock exchanges are C-corporations.
Which entity type is right for you?
While there are many things to consider when choosing an entity, small businesses that typically have limited investment and distribute the majority of profits to their owners tend to be S-corporations or LLCs. Examples of such businesses include small consulting firms, franchises, handyman services, and restaurants. On the other hand, businesses which intend to raise a significant amount of capital and eventually go public, such as tech start-ups, are often C-corporations.
Contact Peer & Hart, PC for a free consultation to determine which entity is right for your new business.