Every entrepreneur faces one basic issue at the beginning of the life of the business – what sort of business entity is best suited for your new company?
Should it be a partnership, a corporation or a limited liability company?
As basic as this question is, there is no simple answer. As with many legal issues, the best approach depends on your situation, such as where your business is located and how many shareholders your start-up is starting up with.
Over the next few weeks, we’re going to discuss the pros and cons of the various approaches.
Our discussion will be focused on two alternatives – a limited liability company (LLC) and an S corporation. Both of these business entities have one very significant advantage in common – they both offer the founding shareholders a crucial tax efficiency by eliminating the problem of double taxation.
Double taxation is taxation at the level of both the corporate entity and shareholder. Double taxation is inherent to all traditional corporate entities although many big companies successfully reduce the tax burden at the corporate level through all sorts of clever stratagems. For early stage companies, while there is often less profit, there will also typically be much less room to maneuver or be creative in terms tax avoidance strategies. Capturing this tax efficiency, by organizing as either an LLC or S Corp, usually proves to be an important consideration for start up investors.
Note, partnerships offer the same basic advantage – the partnership entity is disregarded for purposes of taxation and all income is treated as flowing through to the individual partners. A partnership structure will often prove cumbersome as a vehicle to launch a business start-up and subjects the general partners to personal liability. You may solve the problem of double taxation but end up with a whole host of other problems trying to shoehorn a start-up entity into the legal framework of general and limited partnership interests, with controlling shareholders facing either the potential loss of control or exposure to enterprise liability risk, depending on how they choose to engineer a work-around.
So for that reason, we often advise our entrepreneurial clients to focus their attention on the two remaining alternatives – a limited liability company or an S Corp – as the preferred vehicle for realizing their start up dreams in a tax efficient manner. In the next few blog posts we will examine the advantages and disadvantages of these two options.