What types of entities are there? A business may be formed as a C-corporation, an S-corporation, a partnership, a limited liability company, a limited liability partnership and a sole roprietorship.
The type of entity determines how the entity and its owners are taxed. The choice of entity will also determine how investors are able to contribute to the business and take back a return on their investments. To reduce costs (legal and accounting and time), it is important to choose the best entity for your business.
How does a business choose the most optimal entity type? The choice should be based on the goals of the owner(s). As such, we have broken down the different entities based on broad, but common, goals.
1) No investors, one level of tax:
A sole proprietorship or LLC allows for one level of tax on the owner and is reported on the Form 1040, Schedule C. The ownership of the company is fully disclosed; this makes sense for smaller businesses. The LLC also provides legal liability protection, thus creating a layer between the business and the owner.
2) More than one owner, no outside investors:
An LLC, S-corp, partnership or LLP are flow-throughs for tax purposes, which means that each owner pays tax on the business's income on their individual tax returns and the entity does not pay tax on its own, thus providing one level of tax. Expenses are not disclosed on the individual's return, resulting in less of a chance that the owners will be audited.
An S-corp is a C-corp that makes an election which allows it to be taxed only at the individual level. However, an S-corp cannot have preferred stock and is therefore not a good choice if there will be venture capital investors.
3) More than one owner with outside (venture capital or public) investors:
In this situation, a C-corp is the traditional company that is set up under state law. The company is taxed and then the owners are taxed again when a dividend is paid out – thus double taxation. This is much more costly in terms of overall return if dividends are actually paid.
The state in which a company is established does not influence the state of taxation where it operates. Thus, if the company operates in California and was set up in Nevada, the company will still pay tax in California. Often Delaware is used as the state of incorporation, because Delaware has the oldest corporate law and if the possibility exists of the company going public, this is the state of choice. But if the company is not going public and is operating in California, California should be used as the state of incorporation.
Venture capitalists will invest in C-corps via convertible, preferred stock, as this allows for a round of financing to be completed quickly and efficiently, without creating a separate tax event on the investment. Overall, however, C-corps do not make sense if there will not be venture capital money or the company will not go public.
The choice of entity to use for a business is best decided in consultation with either an accountant or a lawyer who understands your business and goals. As mentioned previously, it is costly and time-consuming to redo an initial set up because the process was done improperly to start with.
Also, once set up, it is important to maintain the corporate minutes and adhere to the bylaws or operating agreements such that a lawsuit cannot "pierce the corporate veil."
Montage Services Inc. provides international and domestic tax consulting and advisory services, primarily for corporations. To inquire about a particular tax issue or seek consulting services, contact Scott Wentz, managing director, at (415) 963-4016 or scott@montage-services.com.
