Corporate Entities
I'm taking a turn on MBA Mondays today. We are moving past the concepts of interest and time value of money and moving into the world of corporations. Today, I'd like to talk about what kinds of entities you might encounter in the world of business.
First off, you don't have to incorporate to be in business. There are many people who run a business and don't incorporate. A good example of this are many of the sellers on Etsy. They make things, sell them, receive the income, and pay the taxes as part of their personal returns.
But there are three big reasons you'll want to consider incorporating; liability, taxes, and investment. And the kind of corporate entity you create depends on where you want to come out on all three of those factors.
I'd like to say at this point that I am not a lawyer or a tax advisor and that if you are planning on incorporating, I would recommend consulting both before making any decisions. I hope that we'll get both lawyers and tax advisors commenting on this post and adding to the discussion of these issues. I'll also say that this post is entirely based on US law and that it does not attempt to discuss international law.
With that said, here goes.
When you start a business, it is important to recognize that it will eventually be something entirely different than you. You won't own all of it. You won't want to be liable for everything that the company does. And you won't want to pay taxes on its profits.
Creating a company is implicitly recognizing those things. It is putting a buffer between you and the business in some important ways.
Let's talk first about liability. When you create a company, you can limit your liability for actions of the corporation. Those actions can be for things like bills (called accounts payable in accounting parlance), promises made (like services to be rendered), and lawsuits. This is an incredibly important concept and the reason that most lawyers advise their clients to incorporate as soon as possible. You don't want to put yourself and your family at personal risk for the activities you undertake in your business. It's not prudent or expected in our society.
Taxes are the next thing most people think about when incorporating. There are two basic kinds of corporate entities for taxes; "flow through entities" and "tax paying entities." Here is the difference. Flow through corporate entities don't pay taxes, they pass the income (and tax paying obligation) through to the owners of the business. Tax paying entities pay the taxes at the corporate level and the owners have no obligation for the taxes owed. Your neighborhood restaurant is probably a "flow through entity." Google is a tax paying entity. When you buy 100 shares of Google, you are not going to get a tax bill for your share of their earnings at the end of the year.
And then there is investment/ownership. Even before we talk about investment, there is the issue of business partners. Let's say you want to split the ownership of your business 50/50 with someone else. You have to incorporate to create the entity that you can co-own. And when you want to take investment, you'll need to have a corporate entity that can issue shares or membership interests in return for the capital that others invest in your business.
So now that we've talked about the three major considerations, let's talk about the different kinds of entities you will come across.
For many new startups, the form of corporate entity they choose is called the LLC. It stands for Limited Liability Company. This form of business has been around for a long time in some countries but became recognized and popular in the US sometime in the past 25 years. The key distinguishing characteristics of a LLC is that you get the limitation of liability of a corporation, you can take investment capital (with restrictions that we'll talk about next), but the taxes are "flow through". Most companies, including tech startups, start out as LLCs these days. Owners in LLC are most commonly called "members" and investments or ownership splits are structured in "membership interests."
As the business grows and takes on more sophisticated investors (like venture funds), it will most often convert into something called a C Corporation. Most of the companies you would buy stock in on the public markets (Google, Apple, GE, etc) are C Corporations. Most venture backed companies are C Corporations. C Corporations provide the limitation of liability, provide even more sophisticated ways to split ownership and raise capital, and most importantly are "tax paying entities." Once you convert from a LLC to a C corporation, you as the founder or owner no longer are responsible for paying the taxes on your share of the income. The company pays those taxes at the corporate level.
There are many reasons why a venture fund or other "sophisticated investors" prefer to invest in a C corporation over a LLC. Most venture funds require conversion when they invest. The flow through of taxes in the LLC can cause venture funds and their investors all sorts of tax issues. This is particularly true of venture funds with foreign investors. And the governance and ownership structures of an LLC are not nearly as developed as a C corporation. This stuff can get really complicated quickly, but the important thing to know is that when your business is small and "closely held" a LLC works well. When it gets bigger and the ownership gets more complicated, you'll want to move to a C corporation.
A nice hybrid between the C corporation and the LLC is the S corporation. It requires a simpler ownership structure, basically one class of stock and less than 100 shareholders. It is a "flow through entity" and is simple to set up. You cannot do as much with the ownership structure with an S corporation as you can with a LLC so if you plan to stay a flow through entity for a long period of time and raise significant capital, an LLC is probably better.
Another entity you might come across is the Limited Partnership. The funds our firm manages are Limited Partnerships. And some big companies, like Bloomberg LP, are limited partnerships. The key differences between a Limited Partnership and LLCs and C corporations are around liabilities. In the limited partnership, the investors have limited liability (like a LLC or C corporation) but the managers (called General Partners) do not. Limited Partnerships are set up to take in outside investment and split ownership. And they are flow through entities.
There are many other forms of corporate ownership but these three are among the most common and show how the three big issues of liability, ownership, and taxes are handled differently in each.
The important thing to remember about all of this is that if you are starting a business, you should create a corporate entity to manage the risk and protect you and your family from it. You should start with something simple and evolve it as the business needs grow and develop.
As an investor, you should make sure you know what kind of corporation you are investing in, you should know what kind of liability you are exposing yourself to, and what the tax obligations will be as a result.
And most of all, get a good lawyer and tax advisor. Though they are expensive, over time the best ones are worth their weight in gold.
Comments (Archived):
It’s very easy to spot a lousy entrepreneur: one who worries about legal issues before the product/service.
that is largely true, but it’s very inexpensive (in time and money) to create a basic LLC. and it can come in handy down the road to do that early on.
I agree with you, its like buying baby clothes before the child is born…granted its good to be prepared. But you and your child would be better off once you know if it is a girl or a boy, so you know what TYPE of clothes to buy. Just as Fred stated about businesses, as things get more complicated is when you consider changing entity types.RedMavenMaven IGVC Fund Managerhttp://bit.ly/cNo5Y9
That’s kind of a ridiculous analogy, but I’ll run with it… sure, you don’t know if your baby’s clothes should be pink or blue, but you know they’ll need clothes. It’s smart to be ready.Further, it can always be changed later. Sure it takes some work, but it’s the right move for your business.
Have you had a baby? Trust me — you’ll be sleep-deprived, your breasts will be all chewed up (well, maybe not yours), you won’t want to leave the house. So you’ll be relieved to have a bunch of clothes at the ready, in yellow or white (and not pink or blue) to get you by in the early weeks, and not have the pressure of going shopping.If it’s quick and easy, just do it early. But, indeed, don’t get sucked into a big thing. That’s not necessary.
I’m sorry, but the opposite is true.A lousy entrepreneur risks spoiling a big win for the sake of some simple and quick housekeeping at the very beginning.Did you know Michael Schumacher personally checks the pressure of all the tyres (sic) he might use in a race. It’s a mechanic’s job, but sometimes it’s the little things that prevent big fails.
Thanks for the counterpoint. I’m realizing that it’s good to beware of one-line aphorisms in the startup world.
Might be noteworthy that offshore corporations are also sometimes used by start-ups entering foreign markets (or established businesses venturing internationally) for both international tax structuring as well as a “safer” route to protect business assets and operations, especially in territories with high high business risk / volatility.This interesting discussion speaks to a British business owner who is trying to use a Belize offshore company to do business in Central Africa:http://www.finance30.com/fo…A little left field, but might offer some interesting insights nonetheless…especially the bits about how the chap was using an offshore corporation to structure a private equity investment.
I’ve always wondered why offshore incorporation isn’t more commonly used; it seems to me that there would be substantial tax advantages in the long-run, particularly for non-US investors.Basically: it’s my understanding that if you start off right, you can take IP offshore at a “creation cost” value and build your corporate value offshore. This is of limited value to most US investors, but potentially great value to others. I really don’t have any idea if this is true, but I’ve never seen any discussion of it.Of course, there’s a big cost to doing this if it’s not a well-understood practice.
In a startup that I worked for, they had a British Virgin Islands (BVI) company that held all the IP and licensing and then a California LLC handled the operational day-to-day work. Several investors had offshore investment funds that they wanted to keep offshore, hence the BVI structure. I’m not sure if they were setting themselves up for increased scrutiny or not, but it seemed to work fairly well.
VCs hate off-shore entities. They don’t understand the governance/law and there are tax issues that cab bite them in the rearWe prefer a straight up deleware C corp
We started our company as an LLC and converted to a C Corp. once we realized we were likely going to take in Venture Capital. The conversion was a real pain – so much so that if/when I do it again, I would likely start right up as an S Corporation or C Corp. Speaking of which, you didn’t mention S Corp’s under the flow through entities – given that they can have up to 100 shareholders, I was curious what your thought was as a VC in investing in an S Corp – my thought (although we didn’t do it so it isn’t first hand) is that an S Corp is a nice in-between of the LLC and C Corp – you could go much longer as an S-Corp (even with investors) than an LLC, which would make the conversion more worthwhile than doing it after only a year or two.
I don’t believe that the S corp gives the same limitations on liability. I’d love it if an attorney weighs in on this. Its my belief that the LLC is superior to the S corp at this time in most regards
According to Wikipedia (http://en.wikipedia.org/wik… (and my recollection from when we did this), S Corp’s and C Corp’s are similar in their limitation of liability – and you avoid double taxation for an S Corp too. The main issues were you could only have one class of stock (I forgot that when I posted, I’m guessing this would indeed be an issue for a VC) and 100 shareholders.
Actually you can have two classes of stock in an S Corp, however the only difference can be voting and non-voting. There are no liquidity preferences.
Not an attorney, so you are getting what you are paying for, but here it goes. S corp is the same as C corp as far as liability. You can make an S election in order to get passthrough treatment on gains and losses if you meet a few criteria: single class of stock, limited number of shareholders, no institutional shareholders. As a result, S corps are not appropriate for VC-backed companies. In theory converting an S to a C is simple. All you have to do is do somethiing to blow your S election, like take on a VC investor or issue a second class of stock. You still have all the tax issues associated with converting from a passthrough entity however, and that is where the brain damage lies. The general view is that S corps offer little or no benefit over LLCs and have the disadvantage of being considerably less flexible. As a result, S corps are fading from the scene.
well, the one big benefit of an S-Corp is that for a bootstrap startup that is going right from friends/family to VC money it’s a lot cheaper on the legal fees side to convert to a C-corp when you bring on VC. Converting an LLC ran us around $11k to get everything straightened out which is money that could have gone to much better use.
The rules for subchapter S corporation as are based on federal (tax) law, not state corporation law. (I am a PA attorney, btw). State law governs the basic form (e.g. corporation) – the distinction between S and C status is entirely a creature of the IRS code. There are no differences between S-Corps and C-Corps in terms of liability protection under state law.LLCs have frequently become the default for closely held companies, but may be well inferior to S-corps, depending on the circumstances. For instance, the co-founders may wish to enter into a restricted stock (vesting) agreement, or offer stock option to employees. These types of arrangements are significatnly more difficult to do with an LLC than with a corporation (C or S).(standard disclaimer — this is not legal advice)
Thanks for stopping by and clarifying that. I’m pleased to see the lawyers chiming in
replying to my own comment here. i stand corrected on this. S corps are like C corps in their liability protection. i am going to update the post to make sure people know about them
Lawyer here, disclaimer noted.I am surprised about the number of commenters who have had trouble converting LLCs to C corps. My guess is that you didn’t start with Delaware entities or had complicated capitalization structures. If you had a Delaware LLC and wanted to convert into a Delaware C corporation, the conversion procedure is very simple. If you had an LLC, however, in a state other than Delaware, then you may have needed to add an extra step – create a Delaware LLC AND a Delaware C corporation, and then take two steps to move your out-of-state LLC into a Delaware corporation. That adds expense – paperwork, filing fees, etc. In addition, if you got creative with your LLC capitalization (e.g., issued profits interests), you might find that conversion is not that simple.Most of the businesses I help form are thinking about raising outside capital, which obviously colors my views on choice of entity. For the most part, businesses seeking outside capital are choosing between the LLC and the C corporation. I haven’t found much use for S corporations in this context because of the limitations on ownership and capital structure. They are often the right choice for a consulting entity or other business that produces profits without raising outside capital. But since capital (at least for technology-enabled businesses) is typically raised in the form of preferred stock, the S corporation’s one-class-of-stock requirement knocks that out of the box. In addition, the prohibition against entity stockholders (including relatively informal bodies such as family limited partnerships) further limits the utility of an S corporation as a vehicle for a startup that is raising equity financing.In helping a client decide between the corporation and LLC, I ask a lot of questions about near-term and long-term strategy for the business, because that will generally dictate the optimal choice of entity. If you’re setting up a straightforward software company and you’re fairly confident that (a) you’re going to raise institutional capital (or try to), (b) you don’t expect corporate profits any time soon and (c) you don’t have use for pass-through losses (and neither do your investors), then a C corporation to start may not be a problem. If you want to grant conventional stock options from a qualified option plan, then a C corporation becomes an even stronger choice. In most other scenarios, however, the LLC may be the right choice.As to choice of jurisdiction, I would consider Delaware to be the clear choice in most situations (the main exceptions being single-member entities or businesses that are unlikely to be located outside of a particular state). The main reason is that the LLC and corporation statutes in many states are poorly written and contain traps for the unwary. The Delaware corporation and LLC statutes are flexible and easy to read, and the case law involving Delaware corporations is well-understood by most practitioners (less so with LLCs, but the gap is narrowing). If your principal place of business is in a state other than Delaware, then your overall organizational costs may be a little higher because in addition to the cost of incorporating in Delaware you’ll have to register to do business in that state, but the certainty and recognition accorded a Delaware organization make that a worthwhile investment, in my view.
thanks Jay. that’s pretty much what I see in the market and your commentexplains why
There are at least two reasons S-corps CAN be better than LLC’s: 1. S-corps are typically much better for setting up options pools, different classes of shares, or other ownership-transfer incentive programs/agreements than LLCs and 2. The transition to C-corp from S-corp is less complex and costly. As always, there are big considerations that vary on a State level as well.
yup. That was the big miss in my post. Tried to fix it but your comment does the trick
S corps can only have one class of stock. You can have convertible debt typically, but that is about the extent of your structuring options.
Hey Fred – great post. I’m a corporate attorney specializing in the representation of entrepreneurs and briefly addressed the issue of best choice of entity on my recent “Ask the Attorney” post on VentureBeat: http://bit.ly/5dZPSZ. I am thus “weighing in” as you suggested.I do not agree with you that an LLC is “superior” to an S corporation. Indeed, if you (as an entrepreneur) will be seeking venture capital funding, you should generally either form a C corporation or an S corporation. The problem with LLC’s are three-fold: (i) it is difficult and complicated to issue “options” to employees/consultants; (ii) conversion to a C corporation can be very tricky and expensive; and (iii) operating agreements tend to be a lot more complex and difficult for entrepreneurs to understand, particularly with all the tax provisions and accounting issues.A C corporation may be more appealing than an S corporation if there will only be a small amount of capital contributions by the founders (thus, limiting the write-off for losses). Moreover, shareholders in C corporations (as opposed to S corporations or limited liability companies) may be eligible for the “qualified small business stock” capital gains tax break under Internal Revenue Code Section 1202; and losses in C corporations (as opposed to S corporations or limited liability companies) may be deductible up to $50,000/year or $100,000/year on a joint return with respect to “Section 1244 stock.”The bottom line, as previously mentioned, is that it makes good business sense for an entrepreneur to sit down with an experienced corporate lawyer and accountant to discuss these issues. Many thanks, Scott (@ScottEdWalker)
What if you’re not looking for venture capital in the beginning (or near future)? What is the cost / benefit of setting up an S-Corp vs. an LLC on day 1, assuming a) I have no money now but b) I will have money in the future?
If VC financing is imminent, from a corporate-law perspective I would set-up a C corp or an S corp, assuming you are eligible for S corp election (e.g., SHs must be individuals and US citizens/residents). Unlike LLCs, S corps are relatively easy to convert to C corps.
ScottEdWalker – this was exactly our experience – converting from an LLC to a C Corp was painful and expensive. If we had to do it again, I’d likely start as an S Corp and then convert to a C Corp if/when I was ready to bring in a VC or lots of shareholders. We could have gone several years longer (IMHO) as an S Corp vs. as an LLC we felt we had to convert. Our employees had no idea what membership interests were (they were used to stock options), and the VC’s wanted multiple classes of stock (obviously, for their preferred).
Thanks Scott – precisely my experience
Thanks for this comment. Very helpful, particularly in clarifying the s corp vs llc issue
i’m an LLC with S Corp tax status. in florida, USA. small business, two shareholders. just doing what i was told by my tax advisor, seems to be working out well for me, at least thus far.
kidmercury, I don’t know what you mean by being an LLC with S Corp tax status? Don’t you have to be one or the other? It’s my understanding that both LLC’s and S Corp have corporate profits flow to the owners, if that’s what you mean. The next question is do you plan to grow beyond two shareholders and/or take on venture capital? If so, how (if at all) would your corporate status have to change?
hey scott, thanks for your reply. to be honest, i don’t know much about this stuff. i just try to find people i trust who i think know what they are talking about. not sure if they actually do! :Danyway, my last accountant and my current accountant said this was the best setup for me. they had me fill out some form to get S-Corp tax status. government mailed some confirmation documents back so i think it’s legit. been like this for about 2 years, have paid taxes, haven’t experienced any problems yet and believe i am in compliance with what the government wants to take from me. maybe it’s a florida USA thing?as for growing, we are in talks to bring on a new shareholder, a corporation based in spain….definitely one of the problems i’m having is that none of the parties involved know how best to structure this! 🙂
From my own personal research on the matter, I believe that an LLC can choose pass-through tax treatment, or corporate tax treatment.
Scott — business lawyer here (disclaimers noted!).An LLC can definitely choose S-Corp status. This is a relatively new development. S-Corp status is only a tax-election with the IRS, and these days, the underlying entity can be either an LLC or a C-Corp.This raises an issue, however, that I don’t think has been discussed here. The fact is that in order to maintain your S-Corp status, the entity must strictly adhere to “corporate formalities” (annual meetings, minutes, corporate resolutions, etc…) which makes maintaining an S-Corp more difficult and time-consuming than an LLC (which in most states is now perpetual and does not require corporate formalities). For many businesses, it will be worth the effort, but you need to know the requirements exist.With an S-Corp, if you fail to maintain corporate formalities, you risk losing your S-Corp status and you will then not be able to get it again for five years, even if you technically qualify. In the past, this was bad news, because the underlying entities were always C-Corps, and a forced conversion from S-Corp to C-Corp could possibly have devastating consequences for the business (including double-taxation on all revenue). Now that an LLC can be the underlying entity, the impact wouldn’t necessarily be as great, except that you would lose some of the significant tax advantages of the S-Corp.With that said, I always recommend adhering to corporate formalities as a best practice (it is also one of the ways you can fight any attempt to “pierce the corporate veil” by showing that the LLC is indeed an independent entity).What I am seeing in this post applies to start-ups that intend to raise capital (makes sense since Fred is the VC guy), have complicated compensation or financial structures, or need to have multiple and varying classes of stock.But so many of the entrepreneurs that I work with on a daily basis are solo or have closely-held businesses, and often the C-Corp is not the best choice for them. For them, the choice is really between an LLC and an S-Corp. There are advantages to both, depending on each individual business’ circumstances. Both have the same limited liability of a C-Corp and both have pass-through taxation. However, for a start-up with no money for a good lawyer, my initial choice would always be an LLC because you can always make an S-Corp election later with the IRS for the time it takes to fill out the election form (**I would always encourage a visit to a good business lawyer before launching, but that just isn’t always practicable for everyone). You MUST consult with an experienced CPA, though, to determine whether your business would benefit from an S-Corp election. In some cases, doing so will save you thousands of dollars a year in taxes. But it can also limit the way you can structure the business financially and how you can make distributions. Do not make this decision without expert guidance.One additional note: it is much easier to convert from an LLC to a C-Corp, than from a C-Corp to an LLC (which involves penalties and costs not involved in converting the other way). When in doubt, start with an LLC so you have protection of some kind, and then as you grow, assess how to proceed or whether an S-Corp election or C-Corp conversion would be a good move. I hate to see any entrepreneur start out as a sole-proprietor and risk their own personal assets right out of the gates.I have two blog posts that discuss these issues for small business owners (who may or may not be planning to pursue VC or investor funding). http://www.jessicaeavesmath…http://www.startupnation.co…
I agree with Mr. Barnett; the extra burdens requited of a C Corp don’t justify the limitations of the LLC, and CERTAINLY if/when you convert the effort (read: money) involved invalidates and “benefit” having started out that way brought you.We always recommend C Corp structure. Always.Further, we recommend doing it in a Corporation-friendly state; there’s a reason that so many of the largest companies call Delaware home, you know (though we prefer Nevada these days).Jeff YablonPresident & CEOAnswer Guy and Virtual VIP Business Change CoachingAnswer Guy and Virtual VIP on Twitter
I think its worth mentioning the DBA (“Doing Business As”), which is not a form of incorporation but just a way to use a different name for your transactions. Its done at the county level, is very cheap to set up, and lets you take payments made out to the name of your business instead of your own name. If your business grows sufficiently, you can incorporate later without changing the name your customers have come to know.A DBA provides absolutely no liability protection, and you put your earnings on your individual income tax.
Yup. I’m not a huge fan of taking on liabilities so I would not recommend this approach except for the simplest of businesses
Given that it takes less than an hour to set up an LLC online (in my state at least), and less than $200, if memory serves, why settle for a DBA? Not only do you get liability protection with the LLC, but you can set up a separate bank account for your business and keep only what money you need in it.Also, what if, before you incorporate, someone takes your DBA name as a corporate name?
In California at least, an LLC has to file an update with the statetwice per year. The $20 fee is minimal, though the penalty for missingan update is $250.A DBA is $39, with no reporting required until renewal five years later.I agree the threshold where it makes sense to create an LLC is awfullylow. Once you have revenue of any sort, its worth it.
We’ve got an annual report requirement in NJ. I’ll found out how much that costs pretty soon.
For a city like New York that is trying to build a start-up culture, the costs to establish an LLC are a travesty. After paying a reasonable $200 fee to the State, New York mandates that you publish notice of formation of your LLC in a print periodical. In the case of Manhattan, it costs from $1,200-$1,500 to “publish” in the NY Law Journal–a periodical that, as far as I can tell, very few people read. The state could put up a simple database on the web for next to nothing so anybody could easily search for LLCs. Instead, they mandate that small businesses pay $1,500 to a privately -owned, politically-connected entity.
To me, the bigger thing in California is the annual $800 tax for having any type of corporation or LLC entity. If it were just the $20-25 update fee, I think more people would just do it.
I believe that the update filing for California LLCs is every 2 years, not twice per year.
A DBA is simply the trade name of the business and should be trademarked if it is vital to the company’s branding strategy. The only benefit of the trademark is the ability to prevent usurpers from using your name. It is serious business.ABC Company, Inc. DBA Joe’s Fish House (TM)One can also file an “assumed name certificate” which prevents someone from using the name of your corporation. In general, Secretaries of State prevent corporations from assuming names which might otherwise confuse the public.
if you are 3 or 4 people and believe you are really on to something – you should be seeking professional help for this stuff right away imo. in Boston we have a host of great firms that have a practice configured specifically to the founding and early financing phase. wilmer hale, and foley hoag are two. i can provide names if anyone is interested. it will pay you back in spades to get corporate side right early on.
I can do the same here in nyc. Great advice mark
For a small startup you expect to grow it often makes sense to start with a S corp so that you can switch to a C corp with a simple box check. S corp is dirt cheap to file and painless to convert to C corp, whereas an LLC to C corp is a costly headache.
Fred, any opinion on the fairsoftware.net model?
i don’t know of it, but i will check it out
Thanks Fred I read over the details of each of these last year when exploring different business models. But it’s great getting an “espresso shot” easy to take in refresher course.Will forward this to my cofounder, keep the info pipeline flowing 🙂
There’s also a ‘new’ entity trying to make it’s way into this discussion as well…the B corporation ( http://www.bcorporation.net ) which is:”B Corporations are a new type of corporation which uses the power of business to solve social and environmental problems.”They are def. not for everyone (yet), but seem interesting enough to be worth watching.
You should know that the B corp is not a legal form of entity recognized by any state. The B corp designation may offer some marketing/branding benefit for social enterprises, but the enterprise still needs address the same state law/federal law incorporation issues as any other entity.
Yep…that’s why I mentioned that they are in the ‘trying’ stage so far 😉
Fair enough. 🙂 There is actually a brand enw legal entity called an Low-Profit Limited Liabilty company (or L3C) that is recognized in Vermont and Michigan, that is intended to bridge the gap between the tradtional for-profit/non-profit distinction for socially-oriented enterprises. IMHO, the L3C is lacking in several important respects, but it may be useful for some.
Victus Media isn’t pulling in revenue yet, at the point it does I’ll gladly seek professional input (legal/financial). Great way to capture why it’s important. The energy spent cleaning up entanglement later will cost your attention in other needed areas.
On the difference between flow-through and tax-paying entities:I think it’s important to point out to newbies on this topic that owners are still on the hook for taxes on distributions/dividends from, and capital gains on the sale of, tax-paying entities.The way the post reads now, it kinda seems like tax-paying entities pay the taxes, and the owners are all set.
good catch. i assumed that was obvious, but it is not.
If you plan on providing incentive ownership to employees, advisors, vendors, etc. you may want to avoid the LLC route. While it can be done, setting up a stock-option like plan in an LLC requires a more lengthy Membership Agreement that ends up costing you more in legal fees. The tax implications and ongoing valuation of membership interests for any kind of incentive plan in an LLC are what make it complicated and a real hassle as the valuation increases.
How difficult is it to convert your structure? I’ve setup my business as an LLC at the moment, to achieve both limited liability and pass through status, and don’t anticipate having any incentive plans in the near term. However, if things begin to pick up this might be an issue down the line.
Converting your structure to a C-Corp is not very difficult. Trying to do the incentive plan within the LLC is not so easy. There are income tax implications to the recipient if you dole out LLC membership interests that have immediate value. There are several work-arounds that a good attorney can propose (I am not an attorney). One is a phantom plan that basically gives the recipient economic benefit without having actual ownership of the membership interest. Easier to convert to a C-Corp IMO.One note regarding attorneys, find someone that can immediately converse on the subject. If they need to go consult a partner in the firm or do reserach on it, then they don’t have any experience with this.
It should also be remembered that corporations, indeed any business entity, end up being political and social institutions as much as they are economic entities. Their constitution, the rules by which disagreements are resolved, both formal and informal, are every bit as important as their tax and liability implications. The underlying conventions and personalities by which a multi-person venture functions is often the difference between success and failure.
Articles of Incorporation, By Laws, Boards of Directors, corporate governance policies, shareholder votes, exchange rules, SEC/PCAOB regulation, management agreements, buy-sell agreements, annual meetings, stock legends, banking covenants and other typical corporate formalities determine how any enterprise “should” be run.In reality, the comity among the Board, the Board’s experience and the Board’s relationship with Management will determine whether it is a talent multiplier or a ho-hum bunch of folks all trying to suckle the same teat.In the end, it is the cooperation of like minded folks who are willing to invest their talents and time in each other who make businesses work.
Could not agree more! Which is why I said “political & social institution” and not a legal one. And why i said both “formal and informal” rules for settling disagreements. Your point about “the cooperation of like minded folks” is the core issue. BUT if they are not like minded the legal structure and the formal rules can quickly cause endless trouble. In short get the social and political structure right by having the right team from the start and the legal side is easy. The reverse rarely works.[An aside comment: once viable social and political structures inside large US corporations are being destroyed by HR and other management systems driven entirely by legal considerations.]
A good contract has never made a scoundrel behave.A bad contract has never prevented a good man from finding the right way forward.The American worker finds himself umemployed today because, in some small part, the relationship between employer and employee has become unnatural through unnecessary litigation and murky rules.We have allowed the “at will” employment arrangement — which employees sometimes fail to appreciate works both ways — to evolve into some kind of poorly understood “contractual” arrangement.While I believe many of the considerations pertinent to the employer-employee relationship are proper and appropriate, the prospect for a “benevolent” employer has almost disappeared.I have provided health, dental, vision and life insurance to my employees, in several companies, for a third of a century [with no government assistance or urging BTW] and only now do they think they are “entitled” to such benefits.
Such a true statement JLM
The liability issue is important, but if you are not incorporated yet at least get similar protection, with explicit contract/terms of use that the service is provided “As is”, no implicit damage etc. Those terms can be found in many legal templates, and off course a lawyer advice can help.
Incorrect on the tax obligations of C-corp owners.It would be more accurate to say that shareholders of tax-paying entities are not taxed on profits until they are distributed.Dividend taxes are very real. I believe the current bunch of looters in DC are pushing for dividends to be taxed as ordinary income. So, first the company gets taxed (GET THOSE EVIL FAT CATS!!!) and then once the remaining profits are pushed out to shareholders, they get pillaged for 39% of the take. also known as compassion.
Absolutely a valid point. Currently dividends are taxed at a reduced capital gains rate and do not allow the taxpayer to reduce their income by their basis in the shares (i.e., if you sell a share of stock your “gain” on the sale is, roughly speaking, what you got for the shares less the amount you originally paid for the shares- “basis”. Dividends do not allow you to reduce by that basis, since you still hold the shares).But, to be a little more precise…the looters in DC aren’t really pushing for anything. The dividend rate provision is going to sunset next year, and Congress doesn’t seem like they’re equipped or willing to do much about it. It’ll put a huge emphasis on corporations holding earnings and trying to make non-dividend distributions.
yup. good point andy
What about the effects of the 1202 capital gains exclusion on the structure you choose? 1202 can be a great benefit to a startup on exit.
good question. hopefully a tax specialist will address it. i don’t want to be giving tax advice
I’ve never come across a post about good tax strategies for the initial formation of the company. A valuable piece of advice from the VC would be guidance on the optimal initial structure for the company that maximizes the benefit to the entrepreneur. Most entrepreneurs don’t know enough in the beginning to ask the right questions. VC could provide a framework and then recommend a tax pro for the details.A related question, how about putting some of your founder’s stock into a self-directed IRA when it is initially worthless? Can it end up in a Roth IRA somehow?
I believe you can convert from a self-directed IRA to a Roth IRA, assuming you meet certain income requirements, but be aware that you would owe income taxes on the conversion. The tax laws for IRA conversions change all the time however so be sure to check with a tax professional at that time.
Imagine the implications of someone like a Facebook founder putting half of their founder’s stock into a self-directed IRA and then converting it to a Roth before the stock had any real value. They could end up controlling billions in a tax free account.
I think you are making this a bit more complicated than it really is.Traditional IRA — tax deduction for a limited amount going in, taxes on all gains coming outRoth IRA — no tax deduction going in, no taxes on gains coming out, income limitations as to eligibility ($150K filing jointly)You can have both a traditional and a Roth IRA. Tons of info on the web.
Great write-up Fred. As a third year law student/someone working with tax and entity issues, you did a great job of laying out important considerations.But, to echo what you and others have said: Get a professional. As simple as flow-through (e.g, partnership) taxation sounds…it’s actually enormously complex.
S Corps limit liability as effectively as C.One reader brought up a good point which in a C corp you do get double taxed if you take money out (once on income a second on dividends)So if you’re planning to build a profitable company without complicated financing then an S really is a very viable option. Lets say you and two buddies are going to build iPhone apps.That being said if you take on VC it won’t work. They can’t get Preferred Shares (which they need) and passing through the profits is a painful from an accounting standpoint.Going from a S to a C is very easy (done it twice), going from a C to an S is tough because if you sell within ten years of conversion you have to pay the “built in gains tax” it would take several pages to discuss what that is but its acronym says it all BIG.
i am going to update the post with a line about S corps. the comments so far indicate that was an oversight on my part.
S corps definitely have some advantages.You can take the losses that year so if you invest $100k of your own money and the corporation looses $90k that offsets $90k of income.You can distribute profits and they are only taxed once. I.e. if the corporation makes $100k it doesn’t get taxed at the 39% corporate rate and then the dividend rate. The distribution is a non taxable event.You also can convert to a C with literally a check of the box.Like all things this isn’t tax advice and you are CRAZY not to have a good attorney BEFORE you get started, but having some education beforehand is priceless in everything, whether it be getting your car fixed, talking to your accountant, investors, and laywers.
that last line is so true!!!!
So you wouldnt suggest forming a corporation over the internet 🙂 ?
Kind of like buying a motorcycle helmet. Spend in proportion to what you think your head/corporation is worth.
Great topic.If you can get a non-founder willing to work for “deferred compensation,” before serious funding what’s the best way to handle this? Like a founder of a S-corporation but with very small ownership and a vesting schedule? What do you expect to see as an investor?Of course you know this, but Mark Suster has written good articles about these early stage logistics on bothsidesofthetable.com
S corp may be better for that depending on the circumstancesI see way more LLCs but there are a number of good comments in this thread about S corps
Fred — have you seen a trend at all in start-ups structuring themselves off-shore? I work for a biotech entrepreneur here in the city and it seems like everyone of his ventures is either based in Bermuda or the Netherlands.In addition to obvious corporate tax exclusions, I’ve heard him say that it makes it significantly easier to go public on other international exchanges.
I have not seen that. I would not like to invest in an off shore company if I can help it
Great post Fred. As a first-time entrepreneur that recently scoured the Web to decipher the pros/cons (and timing issues) of all these entities, I can say that this is a very useful post. I hope it reaches the eyes of many other first-timers!A point on LLCs: Not only are they easy and inexpensive to set up, but they provide maximum flexibility for terms, structure, etc. Lawyers seem to love them because of this flexibility.
On a related note if you wondering whether to go W-2, 1099 or Corp-to-Corp you may want to take a look at http://biztaxtalk.com/node/3.
having nothing to contribute… other than Disqus’s new javascript has made them speedy gonzales…..great stuff.
:))))))
The first thing that anybody contemplating forming a company should do is sit down w/ a good CORPORATE attorney and get the primer on how to form and most importantl, how to operate as a corporation.There is an elegant simplicity in thinking about corporations — corporations limit the liability of their shareholders from the obligations of the corporation. This is the most important structural element.But you don’t get it just by forming a corporation, you must, must, must, must observe all CORPORATE FORMALITIES. If you fail to do this, you will be faced with creditors “piercing the corporate” veil to get at the management and large shareholders.Read up on the proofs of “piercing” in your state. There will undoubtedly be a two pronged test with the first prong being the issue of the observance of corporate formalities and the second prong being the evidence of some public harm (unpaid liabilities, environmental damage, etc).Discuss observing corporate formalities and piercing the corporate veil with your CORPORATE attorney. Then do it and keep exquisite files.I just concluded a 5 year fight with a Southern state’s Department of Revenue on a licensing and regultory issue on this very subject. They contended that our parent corporate was the “real” holder of the licenses (for which it would not have qualified under the regulatory scheme) and that our wholly owned corporate subsidiaries were in effect shams. It was a dopey assertion on their part but we had to defend ourselves nonetheless. It cost $400,000 to win.I SUSPECT THAT ALMOST EVERY NEW CORPORATION FORMED AND OPERATED IN THE VC WORLD BY ENTREPRENEURS IS VULNERABLE TO PIERCING THE CORPORATE VEIL SHOULD SOMETHNG GO WRONG.Obey and observe the corporate formalities and meet with your CORPORATE attorney annually to review the documentation.Word to the wise and $400K of free education!
Anyone knows of this kind of posts applied to canadian law (even better a blog)? I couldn’t find much by myself…. (shame on me I know)
this comment is an ongoing part of “monday night kookonomics,” my contribution to mba mondays here in fredland, in which i view fred’s original post through conspiratorial, paranoid, distrustful lens. for previous editions of MNK, please check my comments in the mba mondays section.certainly, a major theme in the coming new world order is the demise of nation-states, and the rise of networked organizations — grassroots organizations, highly decentralized in nature, relying heavily on peer-production and open innovation. i recommend john robb’s blog for great commentary on this subject. robb does not appear to embrace 9/11 truth and operates from the “official” 9/11 story, but aside from that i find his insight to be very pioneering.in this new world, which also increasingly involves private businesses performing public services (and hence why companies like google increasingly have things like a public policy blog), new business structures will be needed. some movements on this front have been noted elsewhere in this discussion thread. some key themes:1. business structures that can operate internationally, globally2. as virtual currencies increasingly become a part of platform/network economies, platforms will essentially have their own approach to dealing with businesses built on top of them. in this way, platforms will increasingly compete with nation-states. monetary policy is a form of legislation, perhaps the most powerful one, as it relates very closely to tax laws and how economic opportunity is allocated. as platforms grow in influence, they will gain the ability to impact how businessses are structured as well.lastly, now is a good time to remember that in the USA, income tax is unconstitutional.
This may be our future but it will take a long time to get there. I’ll teleport there
Fred, wondering if you have any advice after working with foreign companies? As a Canadian, would it behoove me to LLC or C corp in the USA? Does it open the door to more venture capital if so? Also, do you or others have a State preference? Deleware? Just curious to know what people think.
Stay canadian for now but prepare to incorporate in the US if you get US investors
So – A question regarding ‘changing’ entity type. If you’ve started out as an LLC or S-corp and all of a sudden it looks like you’re going to need to become a C-corp, why can’t you just create a new C-corp and have that new entity simply purchase all the assets of the previous company and also assume all liabilities? It seems like that would be a relatively clean way of “upgrading” your entity structure. Of course, this assumes that there are sufficient liabilities in the earlier company to make the purchase an accounting “wash”…..Second question – can someone provide more detail into what you mean when you say “messy” accounting? I’ve heard that term over and over…. Lawyers have told me, VCs have told me, etc. That it just gets “complicated” or a “pain in the butt” to change entity type or to properly account for profit “flow”. I get that it might take an extra few letters included in your tax returns, but is it really that messy? What are the practical ramifications in those situations? Are we talking another $5k in professional fees or $50k?
i had the same idea for if i ever need to change biz structure — just create a new biz. seems simple, but i know nothing about this topic, so i don’t know…..
This is an extremely simple matter but it comes more from the M & A perspective.Companies frequently purchase the “assets” — as in Asset Purchase Agreement — of an otherwise going concern and the predecessor concern is left to “terminate” and “wind up” its business which is simply an orderly liquidation of any unpurchased assets and satisfaction of any liabilities and terminating the entity charter. This is how companies of any ilk go out of business.This is very, very simple stuff.
Great questions but beyond my skills/experience to answer
Limited Liability Companies for start-ups are OK, but they are not my preference.I prefer S Corporations. They both have limited liability. They both can take investment capital, though the S Corporation restricts the type of investor and the number of investors. And they both allow “taxes to flow through” to the investors.But S Corporations will not drain cash as quickly as an LLC. Investors in an LLC will be required to pay self employment taxes on the profits. If there are five investors, and three are not working and all split $500,000 profit equally in an LLC, the non-working investors will pay self employment taxes of about $12,000 each if they have no other earned income. In an S Corporation, they will pay nothing.In addition, (small amounts considering), the annual fee for the LLC starts at $500. For the S Corporation, it starts at $25.Further, the lawyers seem to charge twice as much to form an LLC as a corporation.Why pay more to get the same thing?
My neighbor is a CFA. He works for the family business and it is extremely lucrative. I asked his opinion and he said they are an S Corp, but wish they were an LLC. I think the choice depends on if your going to solicit outside investors or not down the road. While my business is in its infancy I have a catch 22. If I get a few sales before I find an investor, I don’t need an investor. If I get an investor before I get sales it will be easier to get sales and ramp up faster. Obviously like you mentioned should I get an investor an S Corp is best. But I think an LLC is best if I don’t wind up needing one! Sigh.
Excellent points. Thanks
A lot of the comments have pointed out the complexity of converting LLCs to C-corps, as well as dealing with things like option pools, etc. I think the important thing is to view all three as tools in a toolbox and pick the right one. In my mind, I’d still do a S-corp for a new startup any day of the week and convert to C-corp when it was time. Done it several times, and it was quick, easy and cheap.I’ve done several LLCs, and here is what they are really good at: housing joint ventures that are owned by existing companies. The C-corp I’m involved in created a joint venture with another C-corp. Rather than create a tax-paying entity for the joint venture, it was easy as pie to make the joint venture a LLC with flow-through to the two C-corps.As a reminder, the reason you can’t do this with a S-corp is because a S-corp can’t have any of its shares owned by a non-individual. The LLC is how you get a flow-through entity that can be owned by corporations.
This post is very, very useful. However, while most young entrepreneurs would LOVE to have the kind of expert legal advice many are advocating, paying someone $400 – $800 per hour just ain’t gonna happen on most of our budgets. In our little project, we found a few people who are reasonably priced and specialize in copyright law, incorporating, etc. But there is so much more we’d like to do from a legal standpoint, we just lack the funds.Cash-strapped entrepreneurs (that phrase is probably redundant) should, at the very least, incorporate to avoid liability concerns (it costs about $250 – $500 depending on your state) and then put some money towards legal as you move along. You’re unlikely to get sued when you make $0 in revenue, but it’s never bad to be cautious.
I may have a controversial opinion, here, but I believe that when you look into the future and think about the costs associated with converting from one corporate entity to another, you also need to look at your immediate resources, prioritize your energy, and keep the idea of “cost” in context.If you are two guys with day jobs, who are frantically coding at night to meet a market window in this fast-paced technology environment, what is the “cost” of refocusing your attention and taking time away from product development to dedicate several weeks to creating a business structure that you may never actually need? Are you “costing” yourselves and your company an irreplaceable amount of time? Are you adding another element of risk by adding excessive delay?If an LLC is quick, relatively painless, and offers adequate protection, then maybe it’s “good enough,” especially if it lets you continue to focus on the real work that only you can do — which is building value by putting a product together.If it costs $10,000 in a year or so to do the cleanup to convert to a C-corp, but your product was launched, you have happy customers and you’re getting welcome attention from bigger investors, then maybe that cost is not so bad, in the context of a good future.And in that happy future, you can probably afford to get the good corporate attorney and tax advisor that you really need. IMO
Amen, Wavelengths. I’m all for “good enough”, and focusing out energies where we bring the most value.If we’re focusing out product development on achieving “minimum viable product”, then why over-invest in a bullet-proof structure you don’t need…until you need it, and there’s money to pay for it. The opportunity cost of getting your eye off the product ball is substantial.I’m feeling the same way about patents, by the way.
Just to clarify — all this advice is great, appropriate, necessary, and really well stated. And absolutely priceless for a lot of people here, whether they need this info right now, or they’ll remember it down the road when they really need it.It’s just that I think we need to be aware of where we are in the process.It’s easy for a starry-eyed would-be entrepreneur to get bogged down worrying about corporate structure before the product is well defined or the market appetite is known, etc.On the other hand, I also know horror stories about people who stayed unaware of the facts of corporate structure until they’d created a nightmare of selling “percentages of the company” when they didn’t even have a DBA.This is absolutely essential info.
I like this good enough approach. I’m just reading through the thread. This seems among the best advice so far…except if their are legal wind-down problems (hopefully not)
Awesome Fred. I have been trying to incorporate into an LLC. But it is very complicated even when there is help from places like Amerilawyer.com or Legal Zoom. Each state has different operating rules. I have a business that can be based in LA or NYC. and long term will have offices in both. But I have very little starting capital. There is very little help to guide not from lack of help, but from an over abundance of stuff out there. NY State requires you take out ads in papers for 5 weeks to establish an entity. California requires $800 in upfront tax. The various documents required, people who can legally sign for legal documents. Its not a simple task. Yet the US is the easiest to set up a business supposedly? I am leaning towards Delaware now but still have to deal with paperwork for which ever state I operate from LOL
Fred, this is a good post but it seems easy for readers to infer that the “traditional” advice for a tech startup is to form an LLC and then convert to C corp once the company takes funding. Also (understandably), you don’t go into the importance of Delaware vs other states. I worry about that because a lot of people will ignore your advice to seek qualified counsel, and then they will run off and form an LLC in whatever state they reside in – which is often a bad choice.I may have a distorted view, but I think the traditional route for any tech company that plans to raise outside funding is still: form a Delaware C corp, file a qualification to do business in your principal state of business.
Hopefully people will read this thread because there is a ton of good advice here
Fred and all…thanks for this post and discussion. It raised some issues for a new project of mine that I’m going to rethink.
Hi Fred… Long time reader, first time commenter.I enjoy your blog but you’re perpetuating a very bad myth which is that through corporate entities and legal shields you can avoid the debts of your company. While this is true if you are a non-management type of investor, it’s completely untrue if you are a managing partner regardless of what type of entity you choose.The lesson that many people learn the hard way are that you are completely vulnerable if you are the one who profits from the debts of the company.Not criticizing but I do believe there is far too much propaganda out there suggesting that there is any way to actually avoid taking responsibility for one’s own actions.
Arlo, I can see from your company site that you have a lot of experience in this area, much more than I. Yet it doesn’t seem possible that no properly maintained corporate entity will stop founders from being personally liable for company debts. Is that really what you mean? Consider for example tip 1 at http://walkercorporatelaw.c…
I’m not suggesting people become irresponsible deadbeats but it is true that a founder won’t be personally liable for a company’s debts unless he or she guarantees them personally
Been busy lately, so of course I’m two days late to this discussion. But two nuances about liability do need to be clarified, the latter of which is the most important. (For those of you who don’t know, I sue businesses for a living. Hear me out.)First, Arlo’s point is partly correct, partly not. Although it is common in business is to throw the term “partner” around, a true partner is only present in a true partnership. In a partnership, it is indeed possible for a managing partner to be held liable for the debts of the business. The same is not true for corporations (including LLCs and S-Corps), where even the managers are not liable. This is one of the main reasons that most businesses today are corporations, not partnerships, even though the distinction is essentially irrelevant to the day-to-day business of the firm (except with regard to taxes).Second, and more importantly, as I blogged about some time ago ( http://bit.ly/bp0mrM ), none of these corporate shields will protect you from personal tort liability. The corporate forms will protect you from contractual liability (e.g., the debts of the business), but if you tortiously (such as “negligently”) cause someone harm, even if you committed the tort while in the employ of the company, you and the corporation are both independently liable. If the corporation doesn’t have enough assets to satisfy the judgment, then you’ll be liable to satisfy it.Point is: don’t rely on the corporate form to completely shield you. As I wrote at my blog, “Buy good personal liability insurance and buy an umbrella liability insurance policy. If you’re running a business, buy a good business insurance policy (including liability) and an umbrella policy for it, too.”
Converting your structure to a C-Corp is not very difficult. Trying to do the incentive plan within the LLC is not so easy. There are income tax implications to the recipient if you dole out LLC membership interests that have immediate value. There are several work-arounds that a good attorney can propose (I am not an attorney). One is a phantom plan that basically gives the recipient economic benefit without having actual ownership of the membership interest. Easier to convert to a C-Corp IMO.One note regarding attorneys, find someone that can immediately converse on the subject. If they need to go consult a partner in the firm or do research on the topic, then they are not the right attorney for this. I have found that this topic is out of scope with some excellent attorneys that just don’t have experience in this domain.
Great advice on finding an attorney who knows this stuff cold. The guy who taught me the venture business said that if he ever had to get open heart surgery, he’d find the surgeon who did the most procedures per yearSame thing with venture lawyers. Find one who does it for a living
I know this stuff for French companies, it’s very interesting to see the US equivalent. The US system is much simpler!Here’s my suggestion for an MBA Monday, maybe next week or some other week: *working capital*.Another very important business concept, and relevant for e-commerce companies. Business models such as retailing (and ad networks? they certainly pay publishers late) that have negative working capital are *magic*, and it helps explain the tremendous success of companies like Walmart and Amazon (not sure what the situation is for “online markets” companies such as Etsy or EBay, but your perspective would be interesting there).
I’m absolutely going to cover that topic. I’m trying to get some of the basics down first though
Love the Monday morning series, as it reminds me when I was starting out. As a recovering lawyer, and a serial entrepreneur, I constantly have associates, friends, and family coming to me for advice on formation issues (amongst other things). I think your high level overview leaves out something that always comes as a surprise to these people: the concept of “Piercing the Corporate Veil” of liability protection.As you know there are certain rules, forms and procedures which must be followed as a liability shielded entity, be it S Corp, LLC, C Corp (or even as a limited partner). To not follow these forms strips the liability protection away from the company and exposes the person to personal liability as if they were a sole proprietor. For some reason, people are always surprised by this. Situations arise where records are not kept, annual meetings are not held, control is exerted, or personal funds are co-mingled with the business. When the company is involved in litigation, the owners find themselves on the hook. Depending upon the jurisdiction, any of a laundry list of things could wind up stripping the protection away.Any advisor worth his/her salt will go over this with a new entrepreneur, but since you’re going over the basics, I thought you might want to put it on the record.
Maybe I’ll make that next week’s postJLM also brought this up
Please note I am *not* an attorney or a tax professional. And you should consult one. With that disclaimer on hand, I was reading through the thread and I don’t think this has been mentioned:You can have an LLC entity and elect S-Corp tax treatment. This can have many benefits including:1. You can carve out the owners salary out of the LLC’s income. This can save in taxes since you don’t need to pay employment taxes on that income.2. You can offer better benefits to employees (I believe S corps have more allowances)3. As an LLC you still get less formalities than a Corporation4. **ARGUABLY**, better protection for the partners. This can get complex and really exceeds the scope of a single post or reply.In my experience, making the right selection is not expensive or time consuming. All I needed was a couple hours of CPA time and likewise for the attorney. Assume they charge $400 an hour, that is $1,600 for four hours.However, as the business has grown, we needed to spend more $$ on attorneys and CPA’s…. but that’s expected.If there are attorney’s or CPA reading this, I’d love their feedback on this post :-)Cheers,Marco
Why incorporate in Delaware?
Paramendra -I believe that Delaware has more favorable corporate laws than other states, which is why many large corporations and public companies chose it as a state of incorporation.State of incorporation can also be important in certain industries but that is where an attorney should be able to help you decide.Best,Marco–Marco
Fred-Quick suggestion as addition to your posts to supplement the MBA Mondays theme. Consider a technology tuesday for those of us who are comfortable with the finance/business piece, but couldn’t explain the differences between ruby on rails and python? Just a thought.
Fred and MBA Monday classmates,Forgive me if this is a bit off topic but I thought it might be of interest.I am very interested in the crowdfunding world and recently joined The Biracy Project as a member. The group is crowdfunding a film. The platform can be used for any type of business.What interested me is the idea of “social capitalism”. Essentially, a new model for doing business.Crowdfunding projects I have seen before get dicey if investments are being offered due to SEC and blue sky laws. Biracy has found a unique way around it.The reason I think it is appropriate for this discussion and this group is how new forms of business will change the overall business landscape in the future.I am a capitalist but something Karl Marx once said always stuck in my mind “capitalism will eat itself”. We are seeing that on a big picture scale and business by community seems to work in uniquely interesting ways thus far.If me and my friends gravitate to a certain product or service, why wouldn’t we promote it? And why shouldn’t we “earn” from it? Commerce is a two way street now.Anyway, I hope I am not too off topic. And, since I don’t want anyone to think I am hawking anything here, if anyone is interested in Biracy further, shoot me a tweet at @philbotana and I would be happy to tell you more.Fred, it would be great to get your thoughts on the project and crowdfunding in general.All the best, Phil
I can’t say much about this topic right now but I will soon
I give choice of entity advice for a living and I think an LLC is almost always a difficult for a start-up venture.Partnership accounting is not for the faint of heart and equity compensation is a nightmare.
Disclaimer: I am an attorney–this is not legal advice. Yadda, yadda, yadda…1. Fred–you said, “Let’s say you want to split the ownership of your business 50/50 with someone else. You have to incorporate to create the entity that you can co-own” which is not true. You can have a partnership without any formalities. In fact, there is some danger in starting something new with someone and not formalizing the business structure sooner, rather than later. If things go south, you might find yourself in a dispute and find out that in the eyes of the law, you had a partnership…2. Someone in the comments asked about Delaware. There are many advantages to organizing your business entity in Delaware: favorable corporate law and a body of established case-law for dispute resolution. I would say that if you are planning on seeking VC at some point, organizing in Delaware should be a serious consideration.3. I think you definitely need to beef up the info on “piercing the veil”. It’s so easy for small business owners to forget to observe formalities, or god forbid, co-mingle funds, that I’ve seen way too many novice business people erode any limited liability they think they may have had.And finally, preservation of species plug: if you think a CPA and lawyer are expensive up-front, just wait until you see what they cost after it’s too late… 🙂
Piercing the vail is coming on monday
P.S. These MBA Mondays are *fantastic*… both for the posts and the comments/discussion. Thank you so much for doing them!!
In the discussion on piercing the corporate vale, it is important to note that if you are holding the appropriate meetings and keeping minutes, not using the company checkbook as though it was personal, staying true to your operating agreement in terms of what decisions you are allowed to make and filing taxes on time, it is not easy for someone to pierce the corporate vale.That said, when someone sues an LLC they will probably sue the Managers and maybe even sue the Members. This is the theory of “sue everyone”. I would suggest that an LLC be required to cover legal expenses for the Managers and Members sued in cases like this.One point that would be great for discussion is peoples opinion on liability insurance. I have a friend (attorney) who only uses partnerships for his other businesses, but buys lots of liability insurance as a protection.Thoughts?P.S. I am not a lawyer so don’t think this is in any way legal advice…
I need the form for the LLC, I want to file myself without paying a lawyer fee. can you [email protected]
HIRE A LAWYER!Seriously, I cannot recommend that you do an LLC on your own. Hire a corporate lawyer. Due to the reduced costs of getting LLC’s online, you can probably get a lawyer with experience in organizing LLC’s to do it for a few hundred dollars these days.
Well discussed topics. As a corp and tech lawyer, the biggest practical advice I have to add is this self developed formula: an idea is not a product and a product is not a company. Each of these elements does however require examining the legal implications of what it is that you are doing. The failure to think about these things in advance is *certain* to get you in trouble, from the software guy who had a friend help develop code (and the now the friend claims ownership) to the launch of a product (maybe we should have checked out trademark laws before we paid for packaging) to the creation of an entity to move the project along (we should have just licensed this to someone else who knew what they were doing).
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Hello! I take pleasure in examining your posts every morning. It’s obvious that your thoughts reflect a good deal of other people’s opinions at the same time.
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That’s a great anecdote. Thanks for sharing it charlie
I’m curious what you guys think of this and want to confirm I don’t have a red flag. I’ve had an LLC for a while for a consulting business and have used that to build my startup. I do consulting projects and have used that revenue to bootstrap the start-up, pre-tax, as an expense. A significant saving for me, and is not co-mingled with my personal stuff.I have figured I’d take on the cost and time of creating the separate entity when there was a reason to: need to formalize a partnership, taking in Fred’s Series A etc., and probably would go straight to the S-Corp.Does this all sound kosher? Am I missing anything?
Most LLCs with more than one member have operating agreements that stipulate that distributions will be made in order to provide cash for any tax liabilities arising from the LLC’s operations. You do not have to do it this way, but if the LLC generates income and you do not want to have it make a distribution, you will have to pay any tax liability out of your own pocket. This may not be an issue if the members have other losses that they can use to offset the LLC’s income, but that is treading into a very complicated area where professional advice is a must (in my opinion).
An LLC will flow through the losses if you operate at a loss and you might be able to benefit from that
I see every reason to avail yourself of the benefits of any legal organization which will preclude the tax man from becoming your partner.There seems to be a bit too much emphasis on this issue of “converting” types of legal entities from one to the other. I fail to see any advantage whatsoever.My experience tells me that I would simply “wind up” one, drive a stake through its heart and start the new one from scratch.There is some considerable peace of mind to be developed by not having to explain your entire history (tax, capital structure, ownership, success, etc) every time someone inquires into the history of your company.In addition, the extinguishment of a company’s corporate charter also conveys a bit of practical protection as it relates to liabilities. Legal hygiene is an important consideration in business.I think the most important thing you can ever do in business is to build an impenetrable wall between your own personal finances and the finances of a company you own or found or hold shares in.The second thing is to adequately and completely insure your liability though insurance.
That’s exactly what I was thinking. Thanks, Charlie.
In my state, if an LLC stops paying the annual franchise tax, the Secretary of State will shut them down, eventually. So yes, you can just forget about them. [not legal advice!]