So, you’re ready to turn your idea into a business. You have the business plan and generally know the path forward, except you aren’t entirely sure what legal matters you should address. Here is an overview of a handful of initial matters you likely will want to consider:
Should I form an entity? Yes, assuming your business – like most businesses – will interact with anyone other than yourself. An entity enables you to have co-owners, receive investment capital, employ others, grow the value of your business, and if you observe certain formalities, an entity may help protect your personal assets from your business liabilities.
Which type of entity? This decision will depend on some knowns and some guesses about the future of your business, including your financing plans, who your co-owners and investors are likely to be, the employees you’ll hire, and tax considerations, among other factors. That said, of the many entity types, the most common forms for startups are the limited liability company (LLC) and the corporation.
The LLC provides significant flexibility for ownership and management structuring as well as favorable “pass-through taxation” (i.e., the company does not pay tax on its income; only the owners do), however, the LLC is subject to potentially complex partnership tax rules and may subject owners to self-employment tax rules.
As to the corporation, there are two distinct types: the “S-corporation” or “C-corporation.” The primary difference is that the S-corporation benefits from pass-through taxation (similar to the LLC), whereas the C-corporation itself pays tax on its income, and then, if it distributes the post-tax cash to its owners, the owners also pay income tax (so-called “double taxation”). So, why wouldn’t everyone choose the S-corporation over the C-corporation? Although both the S-corporation and C-corporation have the same governance structure, the S-corporation has strict limitations on who the owners can be (i.e., mostly individuals, a few trusts, but no other entities, such as Venture Capital (VC) funds or the like) and it may only have one class of stock (i.e., it cannot have preferred stock and common stock, often required by certain investors). In contrast, the C-corporation has no such limitations on who the owners are or the equity capital structure, and virtually all public companies are C-corporations and many traditional VC funds can only invest in a C-corporations.