FORMS OF ENTITIES

In general, there are five types of entities from which an entrepreneur may choose when setting up his (her) company. They are (1) a sole proprietorship, (2) a partnership, (3) a limited liability company "LLC", (4) an "S" corporation, and (5) a "C" corporation. Each has its distinct advantages and disadvantages.

SOLE PROPRIETORSHIP

This is the simplest of all entities. Here are the highlights:

  • There is one owner and the profit or loss of the business is reported on the owner's personal tax return on schedule C.
  • Legal registration is not absolutely necessary except to file a DBA with the city or town where the business is located (presuming the owner's name does not appear in the company name).
  • However, there can be many disadvantages:
    • The owner is fully liable for all actions and inactions taken by the company. This is a substantial risk for a biotechnology company. o Succession is an issue.
    • Your health insurance and group term life insurance up to $50,000 of coverage are not deductible. o Once your company is profitable, you may not avail yourself of lower corporate tax rates.
    • Employees may not be compensated with forms of equity; you are the owner and there can be no others.

PARTNERSHIP

A partnership is very similar to a sole proprietorship except that there is more than one owner. Other differences include:

  • While certainly advisable, a legal agreement is not necessary.
  • The company's profit or loss is reported on a partnership tax return (Form 1065) and your share is reported on your personal tax return via a schedule K-1.
  • You may compensate your employees with equity and, in certain situations, you can transfer assets "tax free".

LLC

For the first time, the entity begins to bear some of the legal liability burden, though the amount will vary from state to state. In certain cases, ownership interests may be freely transferred. In most every other way, the LLC looks and feels like a partnership, including the manner of tax reporting.

S CORPORATION

This form of entity is truly a hybrid of the partnership and the C corporation. There can be between one and seventy-five owners. However, there can be only one class of stock, i.e., no "special" owners except by the number of shares controlled. The tax return is a Form 1120S (corporate-like) but the owners' share is reported on a schedule K-1 (partnership-like) and, therefore, the owners' share of the profit and loss is still subject to individual income tax rates. That's good when you are losing money but terrible when you are making money. There is limited liability but you still can't deduct owners' health insurance and <$50,000 group term life insurance.

C CORPORATION

With a C corporation, you may have an unlimited number of owners with as many classes of stock as you desire. Personal legal liability is limited though, certainly, there are many fiduciary responsibilities. You are working in the best interest for all of the shareholders, not just you. The company's income is subject to more favorable corporate tax rates though any dividends paid to you get taxed twice; once at the corporate level and once at the personal level. All insurances are deductible.

The C corporation is the entity of choice if you will be seeking venture capital financing because more than one class of stock may exist. VCs will be issued "preferred" stock, preferable in distributions to owners of common stock, generally the management team. You don't have to choose this type of entity on day one. You can elect to do it on any given day prior to the VC financing or have the financing automatically convert the company on the day of the financing through the issuance of a second class of stock. Some entrepreneurs have elected to have an S corporation until their financing so that they might claim the losses on their personal tax returns. In any case, seek the guidance of your CFO, tax accountant, and attorney in these matters.