One of the most common questions I get asked by entrepreneurs is, “How should we structure our new venture?”
Although it sounds like a simple question, there is no one-size-fits-all simple answer. The three most common business structures — partnership, LLC, and corporation — all come with different costs/benefits and risks/rewards. What is the right structure for one business and one set of founders will likely not be the right structure for a different business with different owners.
For example, start with the issue of liability. Owners of a business always want less liability, right? If having less liability is your main goal, then forming a corporation is often a good option. The one big advantage to being a corporation is that its owners (called “shareholders”) are generally not liable for the debts and obligations of the business, provided that the corporation “plays by the rules” and behaves like a corporation — that is, the entity has regular Board meetings, keeps records, files corporate documents, and remains adequately capitalized. But LLCs also offer limited liability to their owners (called “members”), without many of the regulatory, tax, and administrative burdens that come with running a corporation. In contrast, if you form a general partnership, all partners will generally be personally liable for the debts and liabilities of the business.
But then there’s the issue of income taxes. If you go the corporation route, you are going to face double-taxation. One tax comes at the company-level when the corporation itself pays income tax on its profits, then another tax comes at the owner/shareholder level when individual owners pay income tax on their profit distributions. This double-taxation is one of the biggest drawbacks to forming as a corporation. In contrast, partnerships avoid paying any tax at the entity level. Instead, the partners are subject to individual personal income tax based on their earnings from the partnership. California LLC entities and owners are taxed similarly to partnerships, except that California imposes a small annual fee (minimum $800) on the LLC.
So, LLCs have become very popular because they often give you the “best of both worlds.” That is, they give you limited liability like a corporation plus the beneficial taxation of a partnership. So why doesn’t every new business choose to be an LLC? Because there are some downsides. For example, if your new venture plans on issuing stock options, that will far more difficult, if not impossible, if your venture is formed as an LLC. In fact, LLCs are prohibited from issuing incentive stock options (ISO’s). Being an LLC, as opposed to a corporation, also can make it more difficult and expensive to engage in mergers and reorganizations. Finally, there is the issue of self-employment taxes. The owners of an LLC who work for the entity are going to have to pay self-employment taxes on their share of the LLC’s income, whereas owners who work for a corporation face so such tax because it is paid by the company.
Now you are starting to see why the simple question that started this post does not have a simple answer…
This post discusses only a few of the issues that should be considered. The point of this post is not so much to give you an exhaustive list of the issues, but instead to give you a “flavor” of the type of analysis that is required when choosing the best structure for your company. If you want to read more general articles about the differences between the various business forms, you can find good summaries here and here. If you want a more detailed explanation that digs a bit more deeply into the issues, go here and here.