To run a successful business, a company needs to establish the right legal entity. In the hedge fund business, as in most other businesses, there are four basic business structures from which to choose — LLC, a C Corp, and an S Corp.
Each structure has its advantages and disadvantages that need to be considered before choosing one for your hedge fund.
Pros and Cons of a Sole Proprietorship
A sole proprietorship is a type of business that has no distinctions between the owner and the company itself. In other words, you are the sole owner, and all profits from this structure flow directly to you as an individual. This also means that you will be responsible for all of the debts and liabilities that may arise from your business.
Advantages of Sole Proprietorships:
- A sole proprietor is taxed as a regular taxpayer along with any other income they make from their hedge fund (you don’t need to pay corporate taxes).
- With this business structure, the owner is self-employed, so you don’t have to worry about formation or paperwork. This can be beneficial at the start of a business when there’s little need for funding. There are also no requirements for filing annual reports or paying fees to the state, which saves time and money during the initial stages of a business.
Disadvantages of Sole Proprietorships:
- Liability is the biggest issue associated with a sole proprietorship. The owner of this business structure is personally liable for any debt or legal consequences incurred by the company.
- Securing business loans can be difficult because there’s no collateral or separation between the business owner’s personal assets separate from those of the business.
- The lack of an established record-keeping system and the absence of a legal distinction between the business and its owner can make it challenging for a sole proprietorship to expand.
This is a great option for small start-ups because it doesn’t require much paperwork. But, there are risks with this option as if someone sues your business and wins, you will most likely have to pay for it personally.
Pros and Cons of an LLC (Limited Liability Company)
This is a business structure that provides limited liability to its owners and requires the filing of an LLC application with the state. You can even have a single-member LLC. The business owner or owners of LLCs are not held personally liable for the business debt and the business has a legal distinction from its owners.
Advantages of Forming an LLC:
- LLC owners do not have to pay taxes on their company’s losses and can choose how they want to be taxed, whether it’s as a sole proprietorship or partnership.
- LLC owners have access to a wider pool of resources and financing opportunities because the business is registered with the state. This type of legal entity also makes the company’s growth and expansion easier.
Disadvantages of Forming an LLC:
- It is necessary for hedge fund business owners to regularly file documents with the state to maintain their LLC status.
- LLCs can grow more complicated and expensive to maintain over time due to other fees that are required by the state.
- As your company grows, it may need more legal counseling which can become costly.
In most cases, an LLC is a good business structure for a hedge fund company that is looking to expand and grow into a larger venture with more employees.
Pros and Cons of a C Corp (C Corporation)
A C corporation is a type of corporation that is taxed separately from its owners. This means that the business pays income taxes on its profits and the shareholders also pay taxes on their dividends, even if those profits were taxed at the corporate level.
Advantages of a C Corporation:
- Have the ability to raise money through selling stock, which can be helpful for some growing businesses.
- Offer the opportunity for tax deductions that are not available to other types of organizations. For example, a C corporation can deduct the cost of health insurance premiums for its employees.
This type of corporation is ideal for businesses that plan to have a large number of shareholders.
Hedge fund businesses that are looking to go public or partner with a larger company should consider a C corporation.
Disadvantages of a C Corporation:
- More expensive and complex to set up than other business structures.
- Subject to “double taxation” on profits, which means the business and its shareholders are taxed on profits twice.
- Subject to greater government regulation than other business structures.
In general, a C corporation is a good fit for hedge fund companies that want to raise money from outside sources and have a large number of shareholders.
Pros and Cons of an S Corp (S Corporation)
An S corporation is a type of C Corporation that was designed by the IRS to help small corporations minimize their paperwork while still gaining many of the tax benefits of incorporating.
Advantages of an S Corporation:
- S corporations can take advantage of the reduced liability benefits typically associated with a C corporation, while still enjoying the tax benefits of being a sole proprietorship or partnership.
- Allow for pass-through taxation, which means there is no need to pay corporate taxes on company profits. The so-called “double taxation” issue of a regular corporation is solved with an S corporation because profits and losses are passed directly to the shareholders.
- Hedge fund business owners can reduce their risk of liabilities by limiting their personal financial responsibility for company debt and litigation.
Disadvantages of an S Corporation:
- Stricter requirements for shareholders and minimum distributions, which means a smaller pool of potential investors.
- Limit of 100 shareholders. As a result, it can’t go public without first converting to a C corporation, and is somewhat limited in its ability to raise capital from investors (particularly individual investors, each of whom would be considered a shareholder).
In general, an S corporation is a great fit for hedge fund companies. You avoid double taxation, can raise money from outside sources, and enjoy limited liability protection.
How To Choose the Right Structure for Your Hedge Fund Business
When it comes to choosing a structure for your hedge fund, the best option is often determined by how quickly and ambitiously you want to grow.
LLC and S corporations are better options for small businesses that hope to expand and grow into larger ventures with more employees. These structures help protect owners from personal liability issues while still allowing access to outside funding.
Sole proprietorships are good options for small hedge fund businesses because they are quick and easy to establish, however, they offer limited liability protection
Overall, entrepreneurs should choose their business structure based on the type of work they do and their growth plans.
How to Legally File an LLC or Corporation for Your Hedge Fund
If you have made the decision to form an LLC or corporation for your hedge fund, it is important to understand the legal process and requirements for doing so.
In order to form an LLC, you must file Articles of Organization with your state’s Secretary of State. This document will outline the business name and purpose of your LLC, as well as the names and addresses of its members.
In order to form a corporation, you must file Articles of Incorporation with your state’s Secretary of State. This document will outline the name and purpose of your corporation, as well as the names and addresses of its directors and officers.
Both the LLC and corporate filing processes typically require fees, which vary by state.
It is important to note that both LLCs and corporations are separate legal entities from their owners, meaning that owners are not personally liable for company debts or lawsuits.
If you need help filing an LLC or corporation for your hedge fund business, it is best to consult with a tax adviser or an attorney who specializes in business law.
Hedge Fund Business Entities FAQs
The best business structure for a hedge fund depends on the type of work they do and their growth plans. An LLC or corporation is a good option for small businesses that hope to expand and grow into larger ventures, while a sole proprietorship may be a good option for small businesses that don't expect to expand beyond a handful of employees.
Being a sole proprietor means that you are self-employed and own your business outright, so you are held responsible for all its debts and liabilities. All business income is also taxed as income on your personal tax return, including self-employment taxes.
On the other hand, an LLC offers limited personal liability protection for its members, and all income from the LLC is typically taxed at a lower rate than personal income.
Both LLCs and S corporations are good options for hedge funds that want the limited liability protection of a corporation, with favorable tax treatment, and while still having access to outside funding.
An EIN, or Employer Identification Number, is a unique nine-digit number that is assigned to businesses by the Internal Revenue Service (IRS). It is used to identify businesses for tax purposes.
A hedge fund does not need an EIN unless they have employees. In that case, the EIN would be used to file employment taxes. This applies to both LLCs and corporations.
A sole proprietor does not need to have a separate business bank account, as all business income and expenses are considered part of the owner's personal assets. However, it is a good idea to segregate business and personal assets to make tracking and bookkeeping easier.
An LLC or corporation must have its own bank account, and all income and expenses should be tracked and filed separately.
Start Your Hedge Fund
If you are starting a hedge fund, it is important to understand the different business structures and their benefits. An LLC or corporation can provide limited liability protection for owners and offers favorable tax treatment. It is important to consult with a tax adviser or an attorney who specializes in business law to determine which structure is best for your hedge fund.