What form of entity?

What form of entity?

Rev members can be any type of corporate entity – as long as it’s an organized business entity and not an individual. This leads people to ask – what’s the right type for me? Here’s a layperson’s guide.

If you do nothing, you operate either as a sole proprietorship or a partnership. If you’re going to have employees or operation with any material risk, this is a bad idea for a bunch of reasons. A key one is that you are better off with an entity that limits liability.

Example: Pat, Joe, and Morgan open a coffee shop without forming an entity. Joe spills hot coffee on a customer. Joe, Morgan, and Pat can each get sued and be personally liable – as in, up to and including lose your house personally liable. In a corporation, the corporation gets sued, but the limit of the total liability is the assets of the corporation, not each persons’ pockets. (Note: if Joe intentionally throws hot coffee on the customer, Joe could be personally liable for his or her actions with or without a corporation – but Morgan and Pat would not be.)

That leaves two other types: Corporation or LLC. LLCs are generally easier to form and allow for more flexibility of governance and tax treatment. Corps are more formal, a little more complicated to do, and a little less flexible. However – and this is the kicker – it’s uncommon for institutions to invest in LLCs in a venture capital context. Furthermore, there’s no simple way to “transition” from an LLC to a corporation. This kind of move typically involves starting an entirely new corporate entity and moving the assets, liabilities, and operations of the LLC into that entity. This is time consuming and can lead to negative tax consequences – not to mention that it runs the meter on a lot of expensive and not value-added attorney hours.

So, the litmus test is this: is it possible that your company will ever look for institutional VC investment?

If yes, then form a corporation.

If no, then consider forming an LLC.

The next question is where the entity should be formed. Delaware has been the most common legal home for corporations – it’s straightforward, not too expensive, and most importantly has the longest and deepest history of case law on matters of corporate law. This makes it a predictable place to operate. If your company is not based in Delaware, you can still form in Delaware through use of a registered agent, and you will need to go through a relatively simple “foreign filing” process to operate here in New York State. (Yes, I know that New York and Delaware are in the same country, but in this context “foreign” means a different state.) If you’re forming a corporation, I recommend following this path. For an LLC, either Delaware or New York work; for a smaller company that is not anticipating large investors, New York may be easier.

The IRS recognizes two types of corporations for tax purposes: C- and S-. S-Corp tax treatment is available when all shareholders are people, not institutions, and it allows the corporation to pass through gains and losses to the individual rather than subjecting them to double taxation, which happens in a C-Corp. Good news: filing for S-Corp treatment is simple, and you don’t even need to file to change from S- to C-; once you take on your first institutional shareholder, it happens automatically.

There are lots of great resources on the web that discuss this further. Here are some of my favorites:

Why don’t venture capitalists like investing in LLCs?” from Hank at Dividends and Preferences

Why the Corporation is King for getting venture capital” from Ryan at Startuplawyer.com

Do you need to be a corporation to raise venture capital?” from Jason at Foundry Group and the Ask the VC blog

As always, I’m not a lawyer – and I’m not your lawyer. Please consider consulting one to get advice specific to your situation.

What form of entity?

Rev members can be any type of corporate entity – as long as it’s an organized business entity and not an individual. This leads people to ask – what’s the right type for me? Here’s a layperson’s guide.

If you do nothing, you operate either as a sole proprietorship or a partnership. If you’re going to have employees or operation with any material risk, this is a bad idea for a bunch of reasons. A key one is that you are better off with an entity that limits liability.

Example: Pat, Joe, and Morgan open a coffee shop without forming an entity. Joe spills hot coffee on a customer. Joe, Morgan, and Pat can each get sued and be personally liable – as in, up to and including lose your house personally liable. In a corporation, the corporation gets sued, but the limit of the total liability is the assets of the corporation, not each persons’ pockets. (Note: if Joe intentionally throws hot coffee on the customer, Joe could be personally liable for his or her actions with or without a corporation – but Morgan and Pat would not be.)

That leaves two other types: Corporation or LLC. LLCs are generally easier to form and allow for more flexibility of governance and tax treatment. Corps are more formal, a little more complicated to do, and a little less flexible. However – and this is the kicker – it’s uncommon for institutions to invest in LLCs in a venture capital context. Furthermore, there’s no simple way to “transition” from an LLC to a corporation. This kind of move typically involves starting an entirely new corporate entity and moving the assets, liabilities, and operations of the LLC into that entity. This is time consuming and can lead to negative tax consequences – not to mention that it runs the meter on a lot of expensive and not value-added attorney hours.

So, the litmus test is this: is it possible that your company will ever look for institutional VC investment?

If yes, then form a corporation.

If no, then consider forming an LLC.

The next question is where the entity should be formed. Delaware has been the most common legal home for corporations – it’s straightforward, not too expensive, and most importantly has the longest and deepest history of case law on matters of corporate law. This makes it a predictable place to operate. If your company is not based in Delaware, you can still form in Delaware through use of a registered agent, and you will need to go through a relatively simple “foreign filing” process to operate here in New York State. (Yes, I know that New York and Delaware are in the same country, but in this context “foreign” means a different state.) If you’re forming a corporation, I recommend following this path. For an LLC, either Delaware or New York work; for a smaller company that is not anticipating large investors, New York may be easier.

The IRS recognizes two types of corporations for tax purposes: C- and S-. S-Corp tax treatment is available when all shareholders are people, not institutions, and it allows the corporation to pass through gains and losses to the individual rather than subjecting them to double taxation, which happens in a C-Corp. Good news: filing for S-Corp treatment is simple, and you don’t even need to file to change from S- to C-; once you take on your first institutional shareholder, it happens automatically.

There are lots of great resources on the web that discuss this further. Here are some of my favorites:

Why don’t venture capitalists like investing in LLCs?” from Hank at Dividends and Preferences

Why the Corporation is King for getting venture capital” from Ryan at Startuplawyer.com

Do you need to be a corporation to raise venture capital?” from Jason at Foundry Group and the Ask the VC blog

As always, I’m not a lawyer – and I’m not your lawyer. Please consider consulting one to get advice specific to your situation.

By: Tom Schryver, Executive Director for the Center for Regional Economic Advancement