I am often asked by founders what type of entity they should form. And like any self-respecting lawyer, I always respond with the same answer: “It depends.”
This is almost immediately followed by a series of questions designed to determine the founder’s goals in starting a business, such as:
- What are your goals for the business?
- What is your exit strategy?
- Do you want you and your family to work for the business?
- How do you plan to finance the business?
- How do you feel about giving up some control?
- How well do you listen to advisors?
The idea is to piece together the puzzle of factors that go into what entity structure is right for the individual circumstances presented. For the vast majority of founders, this comes down to a choice between two entities: corporations or limited liability companies (LLCs). More specifically, an LLC taxed as a partnership, or a corporation taxed as a C-corp or S-corp election. We will set aside professional service entities (such as PLLCs and PCs), benefit corporations and S-corp elections for another day.
Fundamentally this is all about determining whether the company is going to be a closely held lifestyle business or a high-growth, venture-backed business. Neither path is right or wrong, but the decision to pursue either must align with the vision, goals and values of a founder.
To help illustrate this with first-time founders, I will often use a service firm like a real estate broker or a trendy local diner as examples of a closely held lifestyle business. For an example of a high-growth, venture-backed business, I can now fortunately cite Buffalo’s very own ACV Auctions’ growth trajectory and eventual IPO.
Despite some misconceptions, this distinction does not necessarily come down to the market segment or even the idea; high-growth, venture-backed businesses are not just technology companies or the latest app, though these are common examples. The differentiator is the vision and growth strategy of the business and, ultimately, the market opportunity for growth and return for investors.
Once you know what your goals are and what type of business you are trying to be, you can then determine what business entity form makes the most sense for you.
Generally speaking, with a high-growth venture, you are better off forming as a corporation — the primary reason being that it is the preference of most investors and venture capital funds. In fact, if you are not a C-corporation, many investors will require you to convert to one before they will make an investment. There are legitimate corporate governance and tax reasons investors prefer C-corporations and, when you’re the one controlling the checks, you are generally going to have more leverage.
Admittedly, this flies in the face of the traditional advice you will hear in the classrooms of business schools and law schools that preach about the perils of corporations and double taxation. This traditional advice, however, often ignores the impact of self-employment tax, the tax rate parity that the Tax Cuts and Jobs Act of 2017 created, and the reality that most startups do not see taxable profit until an exit.
More importantly, it also ignores that the primary purpose of investors is not to pull money out of a company in the form of dividends (which would trigger double taxation), but to use that capital to accelerate growth until an exit transaction and liquidity event with substantial return on their investment. Even under the best of scenarios, the implications of being taxed as a partnership versus a corporation have become spreadsheet decisions to make with your accountant on a case-by-case basis.
This discussion will sometimes bring up the suggestion that founders may be better off starting out as an LLC taxed as a partnership, converting to a C-corp down the road if needed. The primary driver of this scenario is that the founders will be self-financing for a period of time, will create pass-through losses from being active in the company, and can use those losses to offset gains elsewhere. Or perhaps the founders are uncertain about what path they want to be on; why not just start as an LLC and convert to a C-corporation down the road to hedge their bets? While legally this can be done, doing so comes with some words of caution.
The primary issue when choosing to convert from an LLC to a corporation is that you may trigger significant tax consequences. First might be something called the “hot asset rule,” which will make you recognize income on any inventory or accounts receivable. Second, if you have taken losses and have a negative capital account (especially after taking on debt), you may end up with phantom income in the way of recognized gains upon conversion. In short, this means you may end up owing the IRS and your state of residency a significant amount of taxes — not something most founders look forward to.
Starting a business involves a lot of considerations and planning. A key piece of that should always be legal and accounting advisors that are experienced with startups to help you set the best strategy possible.
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Disclaimer: This article is meant for informational purposes only and does not constitute legal advice or create an attorney client relationship. Should you or your company be facing legal issues, make sure to consult with an attorney about the facts and circumstances unique to your situation.