Taking the Plunge - How to Choose the Right Business Entity for Your Business
In my last post, I discussed the basic characteristics of the main choices available to those wishing to establish a new business in Ohio. Essentially, there are three realistic choices: limited liability company (also known as LLC), S-Corp, and C-Corp. Which choice is most appropriate in any particular circumstance depends on a number of factors (which you should of course discuss with your attorney and possibly your accountant as well), but here are some general considerations.
For Self-Sufficient Businesses. If the business has only a few owners, is locally focused, and is relatively unlikely to be seeking substantial outside investment from venture capitalists or otherwise, the choice can be narrowed to either an LLC or an S-corporation in most cases. For this sort of business, the double taxation aspect of a C-Corporation is a definite disadvantage without much redeeming benefit. Moreover, if a business is not otherwise excluded from being an S-Corporation because of the nature of its shareholders or desire to have more than one class of shares, structuring it as an S-Corporation or an LLC in many cases is just a personal preference.Â
The overall flexibility of the LLC and the greater recordkeeping and corporate formalities associated with an S-Corporation may give LLCs an edge for these more personal "lifestyle" owner-operated businesses. If structured as an S-corporation, shareholders would be wise to enter into a Close Corporation Agreement meeting the requirements of Ohio Rev. Code §1701.591 to eliminate the necessity of complying with at least some corporate formalities.
Businesses Seeking Outside Investment. What about businesses that realistically think they will ultimately be seeking outside investors in the form of institutional investors or angel investors? Here the answer becomes more complicated. Conventional wisdom suggests that C-corporations should be the vehicle of choice for these companies, in part because of perceived drawbacks with the LLC or S-corp form. Click here for a more detailed discussion of this point of view. The "market" is often said to be most familiar and comfortable with C-Corporations and to value the potential tax loss carry-forward a start-up company is likely to have.Â
To be sure, there are certain aspects of S-corporations and LLCs which make them unattractive to institutional investors. Because of the restrictions on permissible shareholders of an S-corp, institutional investors are unlikely to qualify, thus making S-corporations unworkable for them. In addition, in part because at least some of the ultimate end-investors in the venture capital fund may be nonprofit entities, institutional investors may be concerned about "unrelated business income" that would "flow through" from an S-corp or an LLC taxed as a partnership.
However, these are in reality "end game" considerations which, while important, should not be permitted to determine formation as a C-corporation in every case. Obviously not every company that thinks it wants outside investment will get it. And for others it may well be many years before they will be able to attract this sort of attention. At least some entrepreneurs ask themselves whether it's possible to "hedge their bets" by starting with an S-corp or an LLC and converting to the C-Corp later. The answer is yes, it is, although there may be some additional cost.Â
The process of converting to a C-corporation from an LLC or S-corporation is relatively straightforward and becoming easier in every jurisdiction. Converting from an S-corp to a C-corp is very easy, involving little more than notifying the IRS of the change. Converting from an LLC to a C-corporation may require a merger and some tax planning to ensure it can be done without tax consequences, but is still a very manageable alternative. In Ohio, conversion of an LLC into a corporation is governed by Ohio Rev. Code §1705.371.
Moreover, when it comes to "angel investors" who are almost by definition, high net worth individuals, the considerations driving selection of the C-corp may not apply. These individuals are very focused on their "return on investment" and when they will start receiving cash flow and may very well welcome the creative capital structures LLCs allow to accommodate these concerns. Depending upon who they are and their relationship with you, they might even prefer a manager-managed style LLC (in which they are passive investors) with certain "guaranteed" returns on the capital they have invested with you. They may also appreciate being able to claim some losses on their individual tax return. Â
The logic of focusing on what makes sense today becomes even clearer when the follow-up question to what form of business entity the company should be is considered. Suppose the decision is made to go with a C-corp; now what state should the new company be incorporated in? The institutional investor is likely to prefer Delaware. However, incorporating in Delaware will also have a number of current consequences, including the possibility of having to defend a lawsuit filed in Delaware even though all business operations are in Ohio. Ensuring compliance with not one, but two, states' business laws will also be required.Â
In the short and medium run, the question is really what will work best for the entrepreneur, especially if the dream of outside money never comes to pass.  While there are certainly some start-ups and early stage companies that should select the C-Corp form, many others should give serious consideration to the other available alternatives.
