Two weeks ago I gave a seminar in Cambridge on the three issues that startup business clients most often ask me about. These were entity selection, IP protection and use of independent contractors. I already covered independent contractors in a recent post, and now I’m following up with entity selection.
Entities are the basic form of your business organization. At the simple end are sole proprietorships and partnerships, and as we go up the complexity latter these quickly devolve into a letter salad of C-, S- and B-Corps, LLCs and LLPs, and hybrids of more than one of the above. Earlier this week, I was explaining to a client that his best course of action might be to start an LLC that’s also a B-Corp and an S-Corp. This might seem a bit ridiculous, but each of these designations brings specific advantages and choosing the right one can save you taxes and protect you from liability while striking the right balance on a sliding scale of state fees, management structure requirements and attractiveness to investors.
Note: Please don’t try this at home. These issues are complex and should be addressed in a discussion with your lawyer. I provide this article for background and educational purposes only – not as a substitute for legal advice, so please don’t make a choice and then use a legal forms website to create your business documents. In the last month I’ve had three different projects that involved undoing damage done by legal forms from a website that did not correctly apply Massachusetts law or failed to give some basic advice that would have headed off problems later. As usual, some of the finer points here are specific to Massachusetts. Please consult a lawyer in your jurisdiction for help with business entity selection or any other issues.
What is an entity and why do I want one?
As Mitt Romney would say, a business is a person. That person – the entity – is either you, the individual business owner, or a fake person that you create on paper to conduct business for you. The fake person, which is a corporation or LLC, is a useful tool. It can be bought or sold, split into shares, managed by directors, own property and intellectual property, make contracts, handle profits in ways that save taxes, and shield its owners from lawsuits.
When the individual or individuals are the entity, the business is referred to as a sole proprietorship or a partnership. This is the simplest and least expensive entity to form, and for some simpler businesses it is sufficient. It avoids “double taxation” on profits that are a disadvantage of some corporations – profits go directly to the owner’s income for tax purposes, but are subject to self-employment taxes, a system known as “pass-through” taxation. The primary drawbacks are that it is difficult to sell or to bring in investments, that it leaves its owners exposed to lawsuits and business creditors and that it does not lend itself to being managed by people other than the owner.
Corporations: The traditional approach
The corporation is the traditional alternative to the sole proprietorship or partnership. It is a fake person, created by filing paperwork with a state, for the purpose of conducting business. It is governed by state laws requiring it to follow certain formalities: It must have shareholder, directors and officers, and must make yearly filings. The Board of Directors must hold meetings and the company must arrange regular shareholder meetings.
In the small company context, this can lead to some rather silly situations in which the company owner must hold regular meetings with himself or herself, send and acknowledge notification of those meetings, and take and keep meeting minutes. These formalities should not be ignored: they are one element of maintaining a working corporate liability shield.
The liability shield, or “corporate veil,” is a valuable if imperfect protection between the company owners and exposure to creditors, including civil lawsuit judgment creditors, of the corporation. Valuable because it means that in most common lawsuits, debt defaults or business bankruptcies, only business assets are at risk. Imperfect because it cannot deflect all types of liability, and failure to follow certain rules can expose the shareholder to “veil piercing” that may invalidate the liability shield.
If a corporation is not an S-Corp or a B-Corp, it is referred to as a C-Corp. Most large or publicly traded companies are C-Corps. The greatest drawback of C-Corp status is what’s referred to as “double taxation” of profits, in which the corporation pays tax on income, and then the shareholder pays tax on profits passed to the shareholder as distributions.
There are other options
Watch this space for my next article, in which I will cover LLCs – the common and simplified alternative to corporations – as well as S-Corp status (a way to avoid double taxation) and B-Corps (a new model for businesses that wish to incorporate public benefits and sustainability into their model).