You have decided to take the plunge and start your own business.  Congratulations!  Now the real work begins.  But if you take things one step at a time, you will be able to tackle all of the operational issues that you will face throughout this adventure.

The first item on your checklist is to form a limited liability entity for your business.  Selecting the right jurisdiction and structure for your new business helps maximize your chances of financial and operational success while at the same time takes advantage of corporate tax breaks. And when faced with the confusing choices for structuring a business, new business owners can become overwhelmed. From corporations to limited liability companies (LLC’s); C corporations to S corporations; and Delaware entities to Massachusetts ones; how does one decide what’s best? It’s important to understand the differences – and similarities in vehicles, especially since categories can overlap – in order to choose what’s right for you.

Two choices need to be made before you embark upon your entrepreneurial journey:

1. Corporation, LLC or something else?
2. Jurisdiction of entity

Corporations, LLCs or Something Else

Sole Proprietorships, Partnerships, Corporations and LLC’s each have their own fiscal and legal benefits, but for the vast majority of companies, the choice really comes down to your business’s tax burden. Sole Proprietorships and single member LLCs don’t necessarily file separate tax returns. Income, profits and losses are reported on Schedule C of the principal’s individual tax return.  Partnerships and LLCs are treated as partnerships and those entities’ income “passes through” to partners’ individual tax return through a Form K-1.  Corporations are taxed in two very different ways: as partnerships where the operations pass through to the shareholders (S Corporation) or as its own individual entity (C Corporation).

While many micro-businesses with minimal risk are sole proprietorships and many professional services businesses (law firms, accounting forms, architectural firms, etc.) take the form of partnerships, the vast majority of my clients choose between corporations and LLCs.

A single member LLC is disregarded for tax purposes and income is reported on the Member’s personal tax returns.  A multi-member LLC’s default tax form is a partnership, but the members may elect to be treated as a corporation.  While an LLC is flexible in its corporate organization, it has limitations for more mature high tech businesses.  LLCs can’t issue tax advantageous stock options and many investors don’t want to invest in an LLC.  Generally, LLCs are useful for real estate investing and small companies with few capital requirements.  If a client is purchasing investment property or opening a consulting business, I recommend forming an LLC.

C Corporations are the standard corporate structure and the default selection when you file your articles of incorporation. C Corporations’ benefits are plentiful – they help keep separate your business and personal finances, permit you to issue traditional stock options and restricted stock, and allow you to sell shares for investment capital raising. However, C corporations contain two levels of tax: (1) the corporation itself is taxed, based on its net income, and (2) the stockholders also are taxed when they receive dividends or liquidation proceeds from the corporation. Don’t be fooled by what you read in the news.  Even with the 2018 corporate tax rate cut (down to 21%), these two layers of income tax can unfortunately result in a combined income tax rate of 45% or more on income earned by the C corporation.  In addition, C corporation start-up losses incurred are not to be used on its owners’ personal income tax returns, whereas they can be with LLCs and S corporations.

S Corporations, while the same type of legal entity as a C Corporation, are taxed very differently.  A business structured as an S Corporation is taxed as a pass-through in order to avoid the double taxation issue altogether.  Potential drawbacks of this structure however are that S-Corp status must be classified as such before the 15^th day of the third month of the tax year (or they will be a C-Corp by default); they must be owned by U.S. individuals or certain qualifying trusts; they must have fewer than 100 shareholders, and they can only have one class of stock (i.e. no preferred stock).

Jurisdiction

While the structure of your business answers most of the important questions, finding the right jurisdiction for your business is important too.  Corporate laws, taxation and costs vary from state to state; therefore you must also choose the jurisdiction of organization, i.e., Delaware, Nevada, or your own home state. Nevada and Delaware do offer unique advantages to small businesses.

Delaware, for example, has market acceptance, a highly developed body of law, special courts devoted to corporate issues, extremely quick and friendly secretary of state offices and tolerable fees for company filings.  Given these factors, most venture capitalists and private equity investors will insist that you reincorporate in Delaware if you did not organize there in the first place.  If my client from the outset considers outside investors, I always suggest incorporating in Delaware.

Nevada is similar to Delaware in that the state has low fees and corporation-friendly laws.  Further, Nevada makes it extremely difficult to “pierce the corporate veil,” which shields your personal assets from corporate liabilities.

If you are operating a small company, then I always recommend incorporating in my client’s home state.  While the fees are often greater, if you form in Delaware or Nevada but you engage in business in another state, it is likely that you will have to qualify your business in that state and pay even more fees.  The only time I don’t recommend home state entities is when a client is purchasing rental properties out of state.  The incorporation state should be the state in which the property resides.

Conclusion

When choosing the right entity type and jurisdiction for your business, be sure not only to consider the present situation but also the future needs and potential longer-range situations.  There are benefits and challenges to each vehicle, but when all the details are considered, the best fitting one should become clearer. Before making this final first decision, experienced legal counsel and tax advisors can help focus the process.