What is the best Corporate Structure for an Early Stage Company?

By Cecilia Chen Esq.


What is the best Corporate Structure for an Early Stage Company?

As an attorney specializing in business entity formation, I have often been asked by my clients whether they should form an LLC or a corporation, specifically an S corporation. Unfortunately, the answer is never a simple one and it depends on a lot of different factors, such as relations between multiple owners, taxes and treatment of assets. By and large, there is no uniform "right" choice. A careful review of the details, strategies and goals of each business needs to be made before an entity structure is chosen.

There are, however, some basic similarities and differences between each entity. I have attempted to provide an overview of these key elements below. But please keep in mind, the information below, by itself, will not allow you to make a proper, informed choice of entity. This should always be done in conjunction with the assistance of your attorney and accountant.

Most start-up small businesses choose between LLC and S-Corporation to avoid double taxation that C-Corporations are subject to. Double Taxation means that all of the income of the C-Corporation is taxed once at the corporate level, then those same revenues are taxed again at the shareholder level when profits are distributed via dividends (please note that in smaller C corps., the double tax may sometimes be avoided by carefully zeroing out of net income each year by paying enough out to shareholder-employees). Shareholders must report any dividend earnings as capital gains on their personal tax returns.

LLC’s and S-Corporations are not subject to the double taxation that C-Corporations are, which is why most start-up businesses choose between LLC’s and S-Corporations. For the majority of small businesses, the relative simplicity and flexibility of the LLC make it the better choice. This is especially true if your business will hold property (such as real estate) that's likely to increase in value. LLC's are usually the entity of choice for real estate ventures for a variety of reasons, primarily due to the tax treatment of real property.

But an LLC isn't always the best choice. Occasionally, other factors may tip the balance toward a S-Corporation. Since both LLC and S-Corporation provide the same liability protection, the decision boils down to several points to consider:

Self-Employment Tax: One of the greatest benefit of a S-corporation is the ability to minimize self-employment tax. Profits of the S-Corp which pass through to the shareholders are not subject to self-employment tax (Social Security and Medicare which is approximately 15%). Rather, self-employment is only taxed on the portion classified as a "reasonable salary". Consult a CPA regarding “reasonable salary”. LLCs and sole-proprietorships must pay self-employment tax on all income.

Treatment of Losses: Deduction on losses in a S-Corp. is limited to the owner’s initial capital contribution; whereas there is no such limitation for a LLC.

Franchise Tax: Both LLC and S-Corp must pay the CA Franchise Tax board a minimum of $800 franchise tax on an annual basis; however the franchise tax is waived for the first year for S-Corporations. LLC on the other hand, must pay franchise tax its first year.

Distribution of Profit and Losses: In a S Corp, there is no special allocation of profit and losses for shareholders. Corporate profits and losses must be split up proportionately to the percentage of shares owned by each shareholder. LLC's on the other hand allow for flexibility as to how they split their profits and losses.

Ease of Conversion: In order to "convert" an LLC into a C-Corp, one actually has to go through a complete merger, whereby a new entity is created, which usually drops down a wholly owned subsidiary, that sub is merged into the LLC, leaving the LLC as the sub of the parent. In short, it’s complicated and makes the lawyers and accountants some extra cash.

Maintenance and Compliance: LLC has the advantage of having relatively few statutory formalities that need to be followed by the owners. The benefit of having limited formalities is that the risk of a claim being brought by a creditor for failure to follow corporate formalities is significantly decreased with LLCs, which reduces the owner's exposure to personal liability. On the other hand, once a S-Corporation is set up, it’s really not that hard to maintain either, especially if that task is delegated to an experienced attorney.

Possible Investments from Future Investors: Private investors and venture capital (“VC”) funds typically cannot (or don’t want to) invest in LLC’s. When a VC invests in an LLC, they risk getting an income tax called UBTI (unrelated business tax income). This type of income is frowned upon by investors in venture fund partnerships and most funds have a provision in their fund agreements that they will use best efforts not to bring UBTI into the partnership. As a result, VC funds shy away from investing in LLC’s. In contrast, converting an S-Corp to a C-Corp is simply a "check the box tax election” (or - actually – “unchecking the box”) - this can be done in a day with a single tax form. No lawyers, no accountants, no money. Therefore, while the LLC has some benefits, the costs of converting the LLC into a fundable entity is substantially higher and usually not worth the additional effort.

In conclusion, each entity structure has its unique advantages and disadvantages. Before choosing an entity structure for your business, a careful review of the details, strategies and goals of each business needs to be made in conjunction with consulting with an experienced attorney and accountant.

Ms. Cecilia Chen provides legal services throughout southern California concentrated in the areas of corporate transactional matters, estate planning, business organization and dissolution as well as bankruptcy. Cecilia received her law degree from American University in Washington DC and completed her undergraduate studies at Boston University majoring in business administration with a concentration in finance. Ms. Chen is licensed to practice law in both California and Virginia, and has extensive experience in representing clients ranging from small and emerging entrepreneurial businesses to large multinational corporations.

Please visit http://www.cclegalgroup.com for more information regarding the services provided by the Law Office of Cecilia Chen, or contact cchen@cclegalgroup.com

Cost Reduction - Part 3

Know your costs


In order to cut costs strategically you must first know your costs. You must be able to see what your costs have been over time and hopefully have a plan for the future.

Knowing your costs is sometimes easier said then done, often the overworked business has not implemented the systems necessary to know their costs and plan them strategically. Quite often small business owner/managers busy themselves trying to hire, train and retain capable bookkeeping staff, rather than analyzing their costs and the strategic effects of these expenditures on the business. If you need help implementing systems to track and maintain your costs, while cutting your costs and freeing up your time to strategically understand your costs CLICK HERE.

Know Where You're Going

Once you have implemented a cost tracking system and you have freed up your time to strategically plan for your company you need to create your plan. Strategy demands that you express clearly the results you intend to achieve. Two things are important here: a) Have the end result in mind before you start, and b) For clarity, quantify that end result.

Strategy needs to be articulated into quantifiable results. With respect to cost reduction, ask yourself what level of profitability are you aiming for? Write it down and refer to it often.

Cost reduction is only a means by which you can increase profits. Cost reduction is not the end result you want; increasing profits is. So don't lose sight of this important distinction. It can have a major impact on the effectiveness of your strategy.

Finally, you must thoroughly understand the ramifications of your decisions, before you make them. It is difficult when you are a busy small business owner to take the time to strategically plan for your company, but it is a step that is imperative to your long-term success. This is the work that keeps you in business; it is planning and organizing the steps you need to take; it includes clearly defining, measuring, and tracking your results. It is precisely this planning that will help you get the result you want increase profits and insure your business success.

In the future installations of this series (coming soon), we'll take a look at some of the tactical steps you can take once you've determined your overall strategy. Stay tuned!