How to Choose the Best Business Entity for Growth and Succession

When launching a new business, one of the most critical decisions entrepreneurs face is choosing the right business entity. This decision not only impacts how the company operates day-to-day but also affects its ability to attract investors or prepare for succession. Thoughtful business structuring from the start lays a strong foundation for long-term growth and stability. The most common options include Sole Proprietorships, Partnerships, Limited Liability Companies (LLCs), and Corporations. An additional notable option is a S-Corporation, which differs from a C-Corporation in how it is taxed. Each entity type offers distinct advantages and considerations, making it essential to weigh these factors carefully.

Partnerships

Partnerships are often the entity of choice for small businesses with multiple owners who want to retain control while benefiting from pass-through taxation. Pass-through taxation means the business’ profits and losses are reported on the individual tax returns of the owners, avoiding corporate level taxes.

Partnerships are often used in professional services or closely-held businesses. Partnerships avoid double taxation, but they also require a high level of personal involvement from each partner, which can be a disadvantage if the business needs to scale quickly or bring in new investors.

Partnerships allow for easy transfer of ownership interests, making them a good option for family businesses that intend to keep ownership within the family. However, they can also be difficult to restructure for growth or when bringing in outside capital.

Corporations

Corporations differ from partnerships in that they are separate legal entities apart from their owners, while partnerships, depending on which structure is selected, can result in owners and their businesses becoming highly intertwined, notably from a liability perspective.

S-Corporations (S-Corps) combine the advantages of limited liability with pass-through taxation and avoiding double taxation. It is a particularly beneficial structure for family-owned businesses seeking to minimize taxes and facilitate ownership transfer to family members. However, S-Corps have strict eligibility rules: they are limited to 100 shareholders, all of whom must be U.S. citizens or residents, and only one class of stock is allowed. These restrictions can make it difficult to raise capital or bring in investors.

While great for smaller, stable businesses with a clear path for succession, S-Corps may not be suitable for companies looking to expand or access significant outside capital, as their eligibility for investors is very limited.

C-Corporations (C-Corps) are the most flexible choice for businesses with growth ambitions or plans to raise capital from a wide range of investors. C-Corps can have unlimited shareholders, including institutional investors, and can issue multiple classes of stock, making it easier for companies to attract outside capital, and ideal for high-growth ventures or those planning to go public.

The primary disadvantage of C-Corps is double taxation: the corporation is taxed on its profits, and shareholders are taxed again on dividends. This is one of the reasons that many business owners decide to select a more tax-friendly entity type in the company’s early years and then include plans to convert to a C-Corp in their growth journey. C-Corps are often the go-to choice for businesses seeking substantial investment or planning for an IPO. For succession, C-Corps can be structured to allow easy transfer of ownership, but the complexity of maintaining the structure requires careful planning.

Limited Liability Companies (LLC)

A LLC serves as a middle ground between corporations and partnerships, offering the flexibility of a partnership with the limited liability protection of a corporation. Like partnerships, LLCs are ideal for businesses that want pass-through taxation but require more flexibility in ownership and management. Owners of an LLC can share profits and losses as they see fit, without the restrictions imposed by S-Corps.

While LLCs are more flexible than other entity types, such as S-Corps, they still face limitations in raising outside capital. Investors often prefer C-Corps for their ability to issue stock and offer a clearer structure for future growth. LLCs are also subject to different state laws, which can make them more complicated to structure in a way that’s attractive to investors.

How to Make the Correct Choice

When choosing the right structure, businesses must balance their goals for growth with their succession plans. For investor-friendly structuring, C-Corps offer the most flexibility, but they come with double taxation and complexity. For succession, S-Corps and LLCs can be more advantageous, providing clear paths for transferring ownership. However, these options may limit capital-raising potential. Just as each company’s journey is unique, so too should be its financial roadmap, customized with elements that align with ownership’s priorities. Sometimes priorities change and planning needs to pivot to align with new goals. Entity conversions come with their own sets of rules and complexities, but an understanding of the intricacies involved enable owners and their advisors to make these pivots in an optimal way.

Some key considerations business owners should factor into their decision on how to  structuring their businesses include:

• Investor Accessibility: C-Corps provide the most flexibility for attracting investors, while S-Corps have strict limits on the number and type of shareholders. LLCs and partnerships may also face challenges in raising capital.
• Tax Efficiency: Pass-through taxation, offered by S-Corps, LLCs, and partnerships, can help avoid double taxation. However, C-Corps allow for more complex structuring, which may benefit high-growth businesses.
• Family Succession: S-Corps and partnerships offer easier paths for transferring ownership to family members, but they may not be suitable for businesses looking for large-scale investments.
• Capital-raising Needs: If raising significant capital is a priority, a C-Corp may be the best choice due to its ability to issue multiple classes of stock and attract institutional investors.

Navigating the complexities of business structuring for investor-friendliness or family succession is crucial for maximizing long-term value. Whether you’re aiming to attract investors or ensure a smooth transition to the next generation, working with knowledgeable advisors can help you make strategic decisions that align with your goals. By carefully considering tax implications, growth potential, and the limitations of each structure, you can optimize your business for both current and future success.

For more information on choosing the right entity type for your business and maximizing its potential, please contact Brent Lessey, Partner and Tax Leader of Anchin’s Consumer Products Group or your Anchin Relationship Partner.