For first-time founders, theres a lot of new territory to navigate. Pretty quickly, you need to figure out product-market fit, customer acquisition costs, and a realistic business model. You need to add to your team and make your first big hires. And you need to understand important legal matters like intellectual property, ownership percentage, and business structures.
In this article, well cover the most common legal business structures, so you can understand which type might be right for your startup. Keep in mind that while this advice is based on my work with tens of thousands of companies over two decades, its general information. Its not a substitute for the advice from an attorney or tax advisor who is familiar with the details of your particular situation.
1. Sole proprietorship/general partnership
The simplest business structure is the sole proprietorship (when theres only one owner) or general partnership (when there are two or more owners). If you never formally set up a business with the state, then youre operating as a sole prop or partnership. This is a completely legit way to operate a business in the U.S., but theres a major downside.
As a sole proprietorship/general partnership, theres no distinction between the owner(s) and the business. This means that all of your personal assets are at risk should your business be sued or cant pay its bills. For many, this is too big a risk to take.
For those of you just out of school and sitting on more debt than assets, take note. You still should be concerned about personal liability, since settlements can actually last up to 22 yearsyou need to think about protecting whatever assets you might have down the road.
Generally speaking, a sole proprietorship can work for some part-time freelancers or for those of you who are testing the waters in the very early stages. But, if youre planning on delivering a product to a customer, you should be concerned about personal liability and should look at one of the formal business structures covered below.
2. Limited Liability Company (LLC)
The key benefit of the LLC is that it helps limit the personal liability of the owner, while keeping the corporate formalities to a minimum. As an LLC, youll typically be required to file an annual report each year with the state and make sure you keep your business and personal finances separate. As well see below, the corporation has many more requirements.
For tax considerations, the LLC can be treated as a pass-through entity: profits and losses are passed along and reported on the owners personal tax returns. If your LLC loses money during its first few years, you can apply your percentage of the loss to your personal return and reduce your personal taxes.
The one main downside of the LLC is that an LLC doesnt have stock. You can give out membership stakes in the business. These ownership stakes are very similar to stock shares, except there arent separate classes of membership stakes with the LLC.
Additionally, if youre thinking about giving employees equity in the company, the LLC can be difficult. The problem is that members own 100% of the LLC at all times, so in order to give equity to someone new, an existing member will need to sell/give some of their ownership to the new member. This can make things much more complicated than just setting aside shares of stock with a corporation.
3. The corporation
Like the LLC, the corporation separates the business owner from the business, helping to protect personal assets from liabilities of the company. But, there are quite a few key differences.
As a corporation, you will have to deal with many more bureaucratic requirements. For example, youll need to create a board of directors, hold an annual shareholder meeting, and document important decisions and actions in meeting minutes. An LLC typically doesnt need to do any of this.
And unlike an LLC, a corporations profits/losses arent passed along to the owners personal tax returns. The corporation itself pays taxes on its profits. If youre planning on putting most of the company profits in your own wallet, this can create an issue: first, the corporation is taxed on the profits and then, youll be taxed personally when you distribute those profits to yourself. This is what we call double taxation.
You can elect S Corporation tax treatment with the IRS to have pass-through taxation like the LLC. But not everyone can qualify; for example, all S corporation owners need to be residents of the U.S. and you cant have more than 100 shareholders.
You might be wondering if there are any advantages to forming a corporation. While a corporation is more complicated to manage and can potentially create a double taxation issue, there are some situations where it makes sense.
First, with a corporation, you can easily set aside shares of stock to distribute to future employees down the road. And from a taxation standpoint, the corporation makes sense when you want to keep money in the company. With the LLC and pass-through taxation, youll be taxed personally on your percentage of the business profits whether you actually see that money or it stays in the business.
And lastly, venture capitalists, accelerator programs, and anyone else that takes equity usually prefer companies to be corporations. This is because investors want to create preferred shares of stock (which isnt possible with an LLC) and its easier to calculate and distribute equity with a corporation. In addition, some VCs are actually restricted from investing in an LLC.
If youre seriously pursuing or considering VC funding, then you may want to create a corporation for your startup. If you think VC funding may be years down the road, then you can start off as an LLC, keep the formalities to a minimum, and convert the LLC to a corporation when you need to.
The bottom line is take some time to understand the different structures and decide which is right for your startup. Most importantly, be sure to protect your personal and minimize the risk of your new venture.
Nellie Akalp is an entrepreneur, business expert, speaker, author, wife and mother to four. She is the founder & CEO of CorpNet.com, an online legal document filing service, where she helps entrepreneurs incorporate, form LLCs, file DBAs and keep their businesses in compliance. Nellie has been named a Top 100 Small Business Influencer by Small Business Trends the last five years and CorpNet.com has been recognized on the Inc. 5000 list of fastest-growing privately-held companies in America in 2015 and 2016.