One of the most important decisions facing your startup is not choosing what consonant to leave out of the name such as Snappr, Letterboxd and DealSpotr or what new, obscure business name you’ll invent such as Zoosk, Skift, Twilio or Piwik.
Surprising, we know.
This important decision is actually a bit mundane, but easy to do. It’s actually making sure you choose which business entity to use when incorporating your business. This simple step can sometimes mean make it or break it for a business if you find yourself faced with liability or a partnership gone wrong.
You probably already know that your startup business needs to have a corporate structure, right? Incorporating your business helps protect your personal assets and lets you open a business bank account to borrow money in your business’s name. There’s also a lot of additional other important steps that come with different incorporations. And, the choice of business entity can also affect the future growth and ultimate destiny of your company. If you want to grow big and build the next billion-dollar “unicorn” startup, you need to choose the right business entity to fit those plans. If you want to stay small and divide up your profits between just a few co-founders or shareholders, there are options for that, too. It all depends on what you envision for your business.
Here are the main types of business entities you can use to incorporate, along with some advantages and disadvantages of each:
A sole proprietorship is the most basic type of business entity. With a sole proprietorship, your business is unincorporated and is operated by one person (you).
- Simplicity: A sole proprietorship is easy to start and easy to run, with very few complications or obligations. Your business income is all reported as personal income on your Schedule C with no separate business tax return required.
- Few protections: The drawback of a sole proprietorship is that it doesn’t really exist as a separate legal structure. Your sole proprietorship is ultimately just “you” doing business out in the world, with no legal protections, tax advantages, or separation of your personal assets from your business assets. Sure, with a sole proprietorship you save some money on filing fees, but is that worth the risk?
In almost all cases, a sole proprietorship is not the best choice for a startup business. If you want to limit your personal liability (and perhaps enjoy some tax savings) while boosting the credibility of your business, you should choose an LLC or other formal business structure.
A limited liability partnership (LLP) is a business entity that can be set up for a business that involves more than one member/owner. It has similar features to an LLC.
- Limited liability: Just like the name says— a “limited liability partnership” limits your personal liability and gives you the help of one or more business partners in running the company. With an LLP, not only is your personal liability limited from the actions of the business, but your individual liability as a partner is also limited against the actions of another partner. For example, with an LLP, if your business partner gets sued, you are not personally responsible for the debts or negligent actions of that partner.
- Good for professional services: The LLP is often a good choice of business entity for professional services firms like law firms, accounting firms or medical practices, where each business partner has a separate professional practice within the larger business (and wants to maintain separate legal protection). Some states require certain professions to use an LLP instead of an LLC.
- Lack of tax flexibility: Compared to a limited liability company (LLC), an LLP has less flexibility on the tax treatment of your business income. An LLC lets you choose to file as an S Corporation, which can help reduce your self-employment tax liability. But an LLP does not offer this option and is a pass-through tax entity, which means that your business income “passes through” and gets directly reported on your personal income tax return.
If you are forming a professional services firm with one or more business partners and your state requires businesses in your profession to use an LLP, then this business entity might be the right choice. Otherwise, an LLC will likely give you the same advantages of an LLP, but with more flexibility (see below).
Limited Liability Company (LLC)
Forming an LLC is often a good choice if your company is just getting started and you’re not sure how fast your business is going to grow.
- Liability protection: By setting up an LLC, you can protect your personal assets from lawsuits.
- No ownership limits: LLCs do not have shareholders like a publicly traded company would. Instead, you can form an LLC with multiple “members” on your leadership team to give all of you an ownership stake in the business. LLCs do not have any restrictions on the residency or citizenship status of the owners.
- Tax flexibility: The LLC is the most flexible business entity. It lets you choose to be taxed as a C Corporation or S Corporation, or you can use the LLC’s “pass-through taxation” to report the company’s income as personal income on your personal tax return.
- No stock: The primary disadvantage of an LLC for growth-minded startups is that it does not allow the issuance of stock.
- LLC termination: If one member of the LLC departs the company, then the LLC is terminated and no longer exists. This is different from other corporate structures that become permanent entities.
An LLC can be a good choice for the early days of your startup, but you might need to switch to an S Corporation or C Corporation as your business grows.
As your startup starts growing, you might think about transitioning into a slightly more complex business entity like the S Corporation. Or maybe it’s best for you to start here… up to you to decide.
- Federal income tax advantages: Unlike C Corporations, the S Corporation generally does not have to pay federal corporate income tax. The S Corporation’s income is “passed through” and taxed on the shareholders’ personal tax returns.
- Flexibility with characterizing income: The S Corp gives you flexibility for tax purposes. You can pay yourself a salary in addition to dividends or distributions that generally get taxed at a lower rate.
- Stock limitations: S Corporations are limited to a maximum of 100 shareholders and can only issue one class of stock. They cannot be owned by foreign shareholders or certain trusts and entities.
- Corporate formalities: Incorporating as an S Corporation (not just filing as an S Corp with an LLC) requires you to set up a Board of Directors and deal with other corporate formalities.
The S Corporation is a good choice if you’re comfortable with your startup’s growth leveling off at a certain point. If you want to grow really large, you’ll probably need a C Corp.
The C Corporation is the business entity for publicly traded companies and high-flying “unicorn” startups. If you want to go public, this is what you need.
- No limits on ownership: The C Corp can have an unlimited number of shareholders, including foreign nationals.
- Multiple classes of stock: Unlike an S Corp, a C Corporation can issue multiple classes of stock, making it ideal for raising capital from investors.
- Go public: Structuring your business as a C Corporation gives you the ability to make an Initial Public Offering (IPO).
- Double taxation: C Corporations have to pay taxes twice! That’s because the corporation itself pays corporate income taxes, and then the shareholders pay tax on any dividends issued to them.
Starting a C Corporation has extra tax complications and compliance requirements, but it’s likely the right choice if you plan for your startup to grow big and go public.
Whatever your choice, our advice is to choose your business entity wisely. The right business entity can help your company grow with the correct structure. As your startup evolves, be aware that your choice of entity might need to change too. After all, your business entity isn’t just a name on a bank account; it’s a vessel for your startup’s hopes, dreams, and hard work.
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