Choosing your start-up entity – Part 1

11 Feb Choosing your start-up entity – Part 1

Part 1: The Flexibility of an LLC
One of the very first questions that many entrepreneurs and start-ups ask is: what form should my company take? This is an obvious candidate for an “early” question, since forming your company is one of the earliest “early-stage” things you will do. Prior columns have addressed the basics of forming an entity, but questions still remain about the differences among the various entities that could be chosen. This column will discuss the usual suspects for start-ups entities.
Before we begin, a word of caution: it is critical to work with your legal and tax advisors when deciding which entity to use. The ultimate decision will be based on many factors, such as taxes, desired management structure, considerations about possible future investments and the like.
The Choices
Many different types of entities are recognized under the law (such as general partnerships, sole proprietorships, limited partnerships, limited liability partnerships and others), but most entrepreneurs will form their company as either a limited liability company (an “LLC”; note that it is not a limited liability “corporation”) or one of the two types of corporations (S or C). Because of the flexibility, relative tax benefits and other features of an LLC, many entrepreneurs will follow that path, but there may be reasons to go another way. In this column, we will look at the LLC, turning to the corporations next time.
The Limited Liability Company
An LLC is formed simply by filing articles of organization with the appropriate state agency. In Wisconsin, it is the Department of Financial Institutions, (DFI, at http://www.wdfi.org/), but in many states the Secretary of State handles this function (see, for example, Illinois at http://www.cyberdriveillinois.com/departments/business_services/home.html, or Delware at http://corp.delaware.gov/). You do not even need to list the owners in the articles, just one or more “organizers,” who need not be the eventual owners—in fact, your attorney often will act as the organizer. There are no restrictions on who can be members of the LLC, including people who are not U.S. citizens and other entities. Although LLCs may issue certificates evidencing ownership, this is not done in most small companies. Finally, membership interests can be structured with different rights and preferences—virtually however the company desires.
The name of this type of entity tells us why this is a very popular option—its members have “limited liability” for the affairs of the business. That is, they are generally not personally liable for the obligations and liabilities of the LLC. However, this can be misunderstood. For example, if you intentionally cause harm to another, you likely will be liable for the harm and cannot use the LLC as a shield. And, the largest obligation of a small business usually is bank debt, and banks will without exception require the owners of the small business to guarantee that debt.
The management provisions of an LLC will typically be found in the LLC’s operating agreement, which will cover everything from capital contributions, distributions, restrictions on transfers of a member’s interest, and management of the LLC. The LLC is incredibly flexible because the management can be structured very formally, like a large corporation, or more simply, almost like a sole proprietorship. Most technology start-ups will be “manager-managed,” meaning that one or more managers will be named to run the day-to-day operations, as opposed to the members themselves.
As for taxes, LLCs are taxed as partnerships. This is relatively simple on the surface: LLCs do not pay income taxes at the entity level; instead, the income and losses flow through directly to the members, so an LLC is often referred to as a “flow-through” entity. The LLC will file a tax return, but it is generally just an information return, reporting the income and losses out to the members, who recognize the income and losses on their personal returns. This is beneficial because the owners only pay one level of tax (we will see how this differs from C corporations in my next column). Partnership tax law allows LLCs to be incredibly flexible as to the allocation of profits and losses, but this flexibility often leads to significant complication. It is highly recommended that you work with advisors who are adept at partnership tax to ensure you handle the tax affairs correctly.
You can see why LLCs are so popular, due to the advantageous tax treatment and structural flexibility. That said, technology start-ups have historically shied away from this type of entity because it was perceived that venture capital investors would not like the pass-through nature of the tax liability of LLCs. However, venture capital firms have steadily gotten more comfortable with LLCs. As a result, they are more and more common with technology start-ups.
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