Eeny, meeny, miny, moe: Picking a legal structure for your start-up

Cody Edwards, Dickinson Law Firm, Iowa Start-Up Group, Des Moines Iowa

Posted on 11/03/2017 at 12:00 AM by Cody Edwards

You have a great business idea, have just completed your business plan, and are getting ready to take your product or service to market. What’s next? One of the first steps is picking a legal structure, which will have implications with respect to liability, funding, and taxes, to name a few. 

There are a wide range of legal structures, each with their own benefits, drawbacks, and unique requirements. This article scratches the surface of issues to consider relative to sole proprietorships, partnerships, corporations or limited liability companies (“LLC”), the legal structures available to the vast majority of start-up companies.

Sole Proprietorships and General Partnerships

These are the default entity types imposed upon companies that have been operating without filing organizational documents with the Iowa Secretary of State. If you’re a one-(wo)man show, you’re a proprietor operating a sole proprietorship. If you have one or more partners, you’re a partner operating a partnership. Sole proprietorships are not separate legal entities from their owners, but partnerships are separate legal entities. Though these entity types do not require filing with the Iowa Secretary of State, sole proprietorships and partnerships operating under a business or fictitious name must record the name of the business with the county recorder. 

As a one-person show, sole proprietorships do not require governance documents. Because partnerships have more than one owner, we suggest the partners enter into a written partnership agreement that sets forth the rights and responsibilities of each partner. Sole proprietorship’s and partnership’s income and losses are filed on, and flow through to, the proprietor’s or partners’ individual income tax returns. This makes them more advantageous, from a tax perspective, than corporations.

Despite the tax benefits, these entities are risky. The owners and general partners of sole proprietorships and partnerships are personally liable for debts of the business and other claims, meaning that the owner’s and partners’ personal assets are at risk. As is discussed below in Limited Liability Company, business owners and partners can obtain the same benefits as sole proprietorships and general partnerships, while also obtaining liability protection, if they form an LLC. Therefore, it is often recommended that an entity operating as a sole proprietorship or general partnership form an LLC.

Corporations

Forming a corporation requires you to file articles of incorporation with the Iowa Secretary of State.  Like an LLC, discussed below, a corporation is a legal entity separate from its owners, and, therefore, provides liability protection to the owners. A corporation should adopt bylaws that,

among other things, define the contours of the corporation’s purpose and governance, including the rights and responsibilities of the Board of Directors, officers, and shareholders.

The default corporation form is the C-corporation. However, business may elect to be an S-corporation, which provides certain financial benefits, only if the corporation meets certain criteria. 

C-Corporation: Most large corporations are organized as C-corporations because C-Corp’s stock classification and shareholder base is not restricted; C-Corps can have more than one class of stock and any number of shareholders. Those shareholders can be individuals, trusts, LLCs, corporations, or other business entities. The downside to being a C-Corp is double taxation.  The corporation pays income tax at the corporate level on its profits and the shareholders pay tax on their personal returns when the corporation makes shareholder distributions. Double taxation can be mitigated somewhat in smaller corporations by, for example, paying out earnings in the form of compensation, within reason, if the shareholder is also an employee of the corporation. 

S-Corporation: An S-Corp is a flow-through entity, similar to a partnership or an LLC, and is, therefore, not subject to double income taxation like a C-Corp. Additionally, unlike an LLC, FICA tax—which is up to 15.3%—is only due on wages, but not due on distributions of earnings. But it is not all good: the owners of the S-Corps cannot avoid tax by manipulating their wages. Rather, the owners must be paid a “reasonable wage.” Self-employment tax savings can be significant compared to self-employment tax paid as an LLC. But, not every corporation can elect S-corporation status due to the following restrictions:

  1. Limited to 100 or shareholders;

  2. All shareholders must be individuals (with certain exceptions);

  3. Only has one class of stock; and

  4. No shareholders are non-resident aliens.  

The takeaway: S-corporation election provides significant benefits, like limited liability, flow-through income tax treatment, and potential savings on self-employment taxes, but the restrictions may cause issues with respect to funding and/or ownership as your company expands.

Limited Liability Company

The LLC is a hybrid legal structure that provides the limited liability advantages of a corporation and the pass through tax advantages of a partnership without the disadvantages inherent in both. Due to the flexibility of and liability protection provided by an LLC, the LLC has become the most popular legal structure in the United States. Forming an LLC requires filing a certificate of organization with the Iowa Secretary of State. An LLC can be owned by a single person, called a

member, or an unlimited number of members and is treated, for income tax purposes, as a disregarded entity, partnership, or corporation. Members can be individuals or business entities. The LLC can be member-managed or manager-managed. Member-managed is a de-centralized form of governance. Manager-managed is more structured, with the managers acting like the board of directors of a corporation.

An LLC should also have an operating agreement that defines the rights and responsibilities of each member. 

An LLC does not provide the FICA tax benefits that an S-corporation provides.  Dividends paid to an S-corporation shareholder are never subject to FICA tax, whereas an LLC’s earnings and profits are allocable to LLC members, who will be subject FICA taxes.

If the LLC is owned by a single member, by default, the LLC will be disregarded for income tax purposes and the profits and losses of the LLC will flow through to, and are filed on, the member’s federal income tax return. If the LLC is owned by more than one member, the LLC is treated, by default, for income taxes purposes, as a partnership. The partnership must file an annual information return with the IRS, and, similar to the single-member LLC, the profits and losses of the LLC flow through to, and are reported on, the members’ federal income tax returns.   

A single- or multi-member LLC can affirmatively elect to be treated as a corporation, in which case the LLC will be treated, for both legal and income tax purposes, as an entity separate from the member or members. Generally, if an LLC elects to be treated as a corporation, the profits and losses of the LLC will not flow through to the members’ individual tax return and will be subject to the double taxation of a C-corporation. However, if the LLC meets certain criteria (discussed in Corporations, above), an LLC may elect to be treated as an S-corporation, in which case the LLC’s profits and losses will flow through to, and be reported on, the members’ federal income tax returns. 

When deciding among the legal structures, it is important to consider the current state of and future plans for your business; having the foresight to determine your business’ future funding and ownership needs may shed some light on the entity form you should and can select today. The issues discussed in this article are just a few of the issues to consider when selecting a business structure and there is no one size fits all approach. 

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If you have questions about entity selection, please contact the Dickinson Law Firm at (515) 244-2600 to speak with an experienced attorney.

This material is not intended, nor should it be construed or relied upon, as legal advice.  Please consult with an attorney if specific legal information is needed.

- Cody Edwards

 

Questions, Contact us today.

 


The material, whether written or oral (including videos) that is posted on the various blogs of Dickinson Law is not intended, nor should it be construed or relied upon, as legal advice. The opinions expressed in the various blog posting are those of the individual author, they may not reflect the opinions of the firm.  Your use of the Dickinson Law blog postings does NOT create an attorney-client relationship between you and Dickinson, Mackaman, Tyler & Hagen, P.C. or any of its attorneys.  If specific legal information is needed, please retain and consult with an attorney of your own selection.

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