A key decision for any startup is which entity type to choose—and choice of entity for biotech startups is no exception. The primary advantage of forming a legal business entity is to shield the personal assets of the owners from the liabilities of the business. Entity selection, whether LLC, partnership, or corporation, has broad implications for the business. Tax, founder, management, employee, and exit strategy considerations should be weighed before making a decision.

Partnerships are generally not used by startups of any type, including biotechnology startups, because they do not offer sufficient advantages over other entities such as an LLC. A partnership can either be general—with unlimited liability for the partners, or limited which subjects the partnership to the California franchise tax. Partnerships are pass-through entities for taxation purposes, meaning any income flows through to the partners and must be reported on their individual income tax returns.

The LLC is a more common entity chosen by startups, including those in the biotech sphere. Owners of an LLC enjoy limited liability similar to that of a corporation, while retaining some benefits of partnership. That contributes to the enduring popularity of the LLC: owners may have both a corporation-style liability shield and the pass-through federal income tax benefits of a partnership. All members of an LLC enjoy this limited liability, even if they actively participate in the business. An LLC may even elect corporate taxation instead of the default pass-through option, making the LLC a highly flexible business form. However, an LLC is subject to the California Franchise Tax; the financial impact of this may be small or large, depending on the annual gross receipts of the business.

An LLC may operate with no limitations on the nature of its owners, its equity structure, or its governance, giving the owners of an LLC maximum freedom to determine internal structure and operations. An LLC can have a preferred equity structure and can even allocate profits and losses on some basis other than ownership percentage. For example, a founding member who wants to reduce involvement in the management of the business could be paid out on his initial investment in the ownership, plus any agreed percentage of future income, notwithstanding his initial ownership stake.

S corporations are the other popular choice for startups. They function the same as regular corporations except they create pass-through taxation for the owners. Like an LLC, S corporations are subject to the California Franchise Tax. However, S corporations come with additional restrictions. There can only be a maximum of 100 stockholders, only individual persons can be stockholders, no out of state residents can be stockholders, and only one class of stock may be issued. For these reasons, S corporations are generally unattractive to investors, who often want preferred equity positions.

C corporations address this shortcoming, but not without added burdens on the business. As a type of corporation, C corporations remain subject to the California Franchise Tax. They must maintain adequate recordkeeping, capitalization, and separation of personal and corporate assets. They are also subjected to double taxation, with profits being taxed at both the corporate and individual levels when owners receive dividends or distributions. However, a C corporation’s ability to issue stock, including preferred stock classes, makes them supremely attractive to investors.

An LLC or S corporation can be changed to a C corporation without any adverse tax consequences, but the reverse is not true. This may lead some to conclude that an LLC is automatically the best choice, but a holistic review of the owner’s goals, the necessity and timeline of attracting venture capital funding, expected gross receipts of the business, and intended exit strategies is necessary to determine which entity type makes the most sense.

For a consultation regarding your individual business issues, please contact San Diego Corporate Law today!