Many folks are pointing to a coming wave of startups in 2009.  My friend Nathan Kaiser of NPost writes on his blog that we can expect a wave of bootstrapped startups, given the limited capital available, the increase of soon-to-be entrepreneurs, and the ease with which a business can be started.

And I don’t disagree.  It seems that more people are thinking “things are so bad anyways, why not give it a try.”  And more power to them, right?

So what is step one?  For many folks, one of your first steps to formalize a business is to form the business entity.  In a prior post, I laid out some of the reasons why your choice of entity matters.  The basic jist of the story is — pick the entity that fits your business and gives you the most long term flexibility.

Well, what choice should I make then?

Okay, so that bit about “flexibility” makes some sense, but then what choice should I make?

Joe Wallin, a fellow attorney from DWT, offers his take on why he generally encourages technology startups to consider S-Corporations over LLCs on his blog:

“I like S corporations better than limited liability companies as a choice of entity for technology startup companies for the following reasons.

1. S corporations can engage in tax free reorganizations, such as tax free stock swaps; in contrast, limited liability company owners have to pay tax on stock received in such transactions.

2. S corporations can grant traditional types of employee equity, like stock options, more easily.

3. S corporations can more easily convert to C corporations in the event of a venture financing or public offering.”

I happen to agree with Joe’s analysis for the most part — but I’m not willing to quite make it so black and white.  Generally, I think it makes a great deal of sense to go the S Corporation route for folks considering building a high-technology business.  But since there isn’t a one-size-fits-all approach to businesses, let’s assume things are a bit more nuanced in entity selection.

Rules of Thumb to Entity Selection

So, without further ado, here are my “Rules of Thumb” in entity selection:

First off, let’s assume you plan to keep it simple.  While some startups will decide to create very complex structures with entities of various organizational forms located in various jurisdictions (such as setting up an entity in the Cayman Islands or splitting the company into a subsidiary to hold the intellectual property and license it to an “operating” subsidiary), you’ve decided to take a simpler approach (and by simple, I mean a more ‘mean-and-potatoes’ approach.) So, what next?

Here is a list of five basic concepts to consider. Once you’ve had a chance to review these general concepts and “rules of thumb,” you can begin to get more insight into some of the implications of your choices.

RULE ONE

If your business is a one-man or one-woman company and you are making a profit that is in line with what your salary would be if you were not working for yourself, consider forming a single member LLC.

A single member LLC is like being a sole proprietor for tax purposes (profits and losses will pass through the LLC directly to you), but it will give you protection from certain liabilities. An LLC has the simplest tax and accounting rules.  In many cases, if you are a consultant and just plan to keep this as a one-person consulting job, then you’ll fall under this Rule.  One thing to note — if at some point down the road, you decide you need to change your focus, grow the business, maybe take outside funding, and take on a bunch of new employees — this could lead to some headaches down the road.

RULE TWO

If your business is a one-man or one-woman company and you are making big profits (in excess of a typical salary you’d earn working for someone else), consider forming an S-corporation.

The benefit of forming an S-corporation in this scenario is that this structure will save you on self-employment taxes. You can form the S-corporation by incorporating as a standard C-corporation (or LLC in certain cases) and then making a filing with the IRS. The accounting and taxation are more complex in this setup.

RULE THREE

If you are unsure if you’ll ever pursue venture capital financing and, if you were to pursue it, believe you’ll wait a couple of years, consider forming either an S-corporation or an LLC.

The most important and immediate benefit to incorporating or forming an LLC is liability protections. Both entities offer that protection and allow profits and losses to pass-through to the individual for tax purposes. The key here: pick a pass-through entity since you want the tax gains and losses to flow through to the individual, rather than be double-taxed if they come to a C-Corporation.

As Joe Wallin mentioned in his blog, if you are fairly certain that your business plan will necessitate hiring additional people and raising money (from whatever source), I would lean towards the S-Corporation route.  In truth, you can make either of these approaches work, but the S-Corporation is probably a bit simpler and cheaper if you have to issue options and raise outside funding.

RULE FOUR

If your business growth strategy involves raising money from investors in the upcoming 6-24 months, consider forming a C-corporation (but remember, you can form a C-Corporation and make an S-Corporation election with the IRS until you are ready to raise funding).

An outside investor such as a VC will desire to purchase the stock of your company. They will also require that the profits and losses remain with the company and not pass-through to the owners.

RULE FOUR (PART II)

The second part of this Rule is the S-Corporation.  Let’s assume you fall under Rule Four, and plan to raise funds in the next 6-24 months, but you’ve got nothing certain at this point.  So what should you do?

Herein is why the S-Corporation can be ideal compared to forming an LLC.  If you are planning to raise funds, you can form a C-Corporation (let’s say in Delaware, which is probably the most common place for high-tech companies to form).  To make that C-Corporation into an S-Corporation and have pass-through taxation, you simply need to file an S election with the IRS and follow the rules related to S-Corporations.  That’s it.  And then, when you are ready to take funding and issue preferred stock, you simply with forgo the S Election with the IRS, and you’ll automatically convert back into the C-Corporation.  (You will need to handle some tax issues related to the change, but you’d have to do that if you were an LLC.)  So for ease of operations, S-Corporation can be idea.

RULE FIVE

If you are planning to create a high growth company in need of substantial outside funding, consider incorporating in Delaware.

A majority of venture funded companies are incorporated in Delaware. There are a number of benefits from greater comfort among investors to well-established corporate law to fairly low incorporation fees. If you believe your company will become a venture-backed company, Delaware represents a logical choice.  While it isn’t a make-or-break decision, if you are reasonably certain that you’ll need to raise outside funding (particularly try and raise VC funding), then just save yourself the hassle and go DE.

On the other hand, if the plans for your company are less clear and your growth horizon is longer term, plus you are planning to transact business in your home state, consider incorporating (or forming your LLC) in your home state.

Summary

These five broad concepts should offer you some “rules of thumb” for your choices. Obviously, your choice of entity is important, but unlike a diamond, it isn’t forever. Ultimately, you should make your entity choice and jurisdiction based upon research and critical thinking. But you should not let the decision allow you to lose sleep.