13 Mar Choosing your start-up entity
Part 2: The Contemplation of Corporations
In my last column, we looked at a relative newcomer for start-up businesses: the limited liability company. There are many good reasons to look at the LLC for your new company, but you also should consider the old standby corporation. In this column, we will look at the corporation and its two forms.
As I said last time, 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.
Like an LLC, a corporation is formed by filing articles (called articles of incorporation) with the appropriate state agency (in Wisconsin, it’s the Department of Financial Institutions, or DFI, at http://www.wdfi.org/). Unless an election is filed with the IRS (more on that below), a corporation will be a C corporation. Like an LLC, there are no restrictions on who can own stock of a C corporation. The corporation will issue stock certificates to the shareholders to evidence ownership. And a C corporation can have any number of classes of stock, with different rights and preferences on each class.
The shareholders of a C corporation also enjoy the same limited liability as do members of an LLC. Remember, though, that such limitation on liability generally cannot be used to shield intentional acts, and loan guarantees will ensure that most small business owners are personally liable for the business’s bank debt.
When management comes into play, things are a bit more formal and structured in a corporation. A corporation has bylaws, which generally contain the management provisions. Those bylaws will call for officers to be named (president, secretary, treasurer, etc.) and will determine how voting and other management works in the company. Corporations with more than one shareholder also will inevitably have a shareholders agreement. This is different from an LLC, in which all of these things are covered in the operating agreement. The corporation also will have organizational resolutions electing the officers and directors and other initial matters, and the corporation will be required to keep minutes of all future meetings or actions of the board and the shareholders.
Income taxes are dramatically different from LLCs. A C corporation is not a pass-through entity, meaning that it must pay federal income taxes (and, generally, state income taxes) at a relatively high rate: 34%-39% for taxable income of more than $100,000 (see a table of all corporation tax rates). If distributions are made to shareholders, those distributions are taxed again, currently at capital gains rates. This double level of taxation is a big reason why most small businesses do not opt to form as C corporations.
S corporations are identical to C corporations in terms of formation, limited liability and management. But that is where the similarities end.
An S corporation is a creation of the Internal Revenue Code, which states that a corporation that desires to be treated as an S corporation must file an election with the IRS. Corporations entitled to file an S election are subject to the following restrictions: they must have fewer than 75 shareholders (which is not often a problem for small businesses); they may have only one class of stock (although the company can have voting and non-voting stock); all shareholders must be U.S. residents; and entities (such as other corporations) generally cannot own any stock. The last two limitations can pose unique issues for technology start-ups if any of the inventors/founders are nonresident aliens or if the business hopes to get money from venture capital firms, which would be prohibited from being shareholders.
Given these limitations, coupled with the formality of corporations in general, why would a new company file an S election? The reasons are taxes and a bit of history. S corporations are pass-through tax entities, meaning that the entity generally does not pay tax. This is very similar to an LLC, but different in some respects, which go beyond the scope of this article. Be sure to consider these aspects, however, because some of them may guide you toward an S corporation. The history involved is that LLCs are relatively new. Before about 15-20 years ago, the only option for owners who wanted the limited liability of a corporation, but tax attributes that approximated partnerships, was to form an S corporation. Also, if a C corporation desires to have the benefits of pass-through taxation, it typically is easier to file an S election than to convert to an LLC.
Which entity to choose for a start-up company involves many considerations, but I hope the last couple of columns gave you a good start as you work through the options with your advisors.
Recent Columns by Sverre Roang
- Sverre Roang: Choosing your start-up entity
- Sverre Roang: Economy presents opportunity for minority, women-owned start-ups
- Sverre Roang: How proprietary is your confidential information?
- Sverre Roang: Lessons in due diligence: Start-ups must get their IP house in order
The opinions expressed herein or statements made in the above column are solely those of the author, and do not necessarily reflect the views of Wisconsin Technology Network, LLC. WTN accepts no legal liability or responsibility for any claims made or opinions expressed herein.