How to Determine the Optimum Legal Structure for Your Business

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The advantages of having an LLC over a Sole Proprietorship

There are four main factors to consider when an entrepreneur decides on the form of organization that best fits in a new business:

  • taxes
  • limitation of personal liability
  • ease of transferability and admission of new owners
  • investor expectation

In almost all cases a founder should form a business first as a limited liability company (LLC) and convert to a C corporation before taking institutional investment or venture capital firm.

Your business can be organized as a sole proprietorship, a general partnership, a limited partnership, an LLC, a “C” corporation, and an “S” corporation. Each type of organization has its own advantages and disadvantages, and we will explain them in this article.

Sole Proprietorship

A sole proprietorship is the easiest type of business to organize. The founder must simply apply for the required licenses to do business in her jurisdiction and away she goes. A sole proprietor can even use her own social security number and need not apply for a federal taxpayer identification number. Tax reporting is easy: Simply report the company’s income and expenses on a form (Schedule C) that the founder will attach to her annual tax return.

A sole proprietor is 100 percent personally liable for all the company’s debts and obligations. This includes vendors, taxes (payroll and otherwise), loans and even lawsuits. It is impossible for a sole proprietor to transfer an interest in the company and remain a sole proprietor, so you are limited in your growth. The risk outweighs the benefit, and it is almost never a good idea for a founder to start a business as a sole proprietorship.

Partnership

A general partnership is simple to form and operate. However, it also provides no liability protection for the partners. Each general partner is completely liable for the debts of the partnership.

In the case of a limited partnership, the LPs are not liable for debts of the partnership. A limited partnership can be very complicated from a tax perspective and can present challenges while operating an ongoing profitable business. Each limited partnership must have a general partner who will be personally liable for the company’s debts, and this person could face personal liability if there are business problems. Partnership tax rules do not allow special allocations among partners, it is not a good idea to start a business using a general or limited partnership.

Corporation
A corporation can provide protection to a founder against the liabilities of the company. This must be managed properly for the corporation to protect the founder. Some things you will need to do: set up a separate corporate bank account, do not pay personal expenses through the corporation, have the corporation’s board of directors authorize certain corporate actions and keep detailed minutes and records.

There are two types of corporations which vary based upon how the corporation will be taxed. S corporations do not pay any federal corporate income taxes. The profits and losses of the corporation will be reported on the individual tax returns of the shareholders. S corporations can have only up to 99 shareholders, cannot have certain types of shareholders including limited partnerships and may have only one class of stock for economic distributions. S corporations can have more than one class of stock so long as the only distinction between the classes is voting but no liquidation preferences that investors often expect.

A C corporation is a bit more flexible, in that it can have an unlimited number of shareholders and can have any number of classes of stock while still providing the limited liability provided by an X corporation. However, because a C corporation is a separate tax-paying entity, it may result in double taxation of a corporation’s profits: once when the corporation earns the profit and again when the shareholders receive the distribution as dividends or as a liquidating distribution. Many investors will insist on a C corporation.

Limited Liability Company

A combination form of organization, a limited liability company (LLC) provides the limited liability protection of a corporation, while avoiding the double taxation. Because it is taxed like a partnership, it can be more flexible than a corporation. For many operating companies this is ideal.

Companies that will not seek venture capital or other substantial outside financing should use an LLC as the form of organization of choice. For those that will seek outside funding, starting as LLCs and convert to C corporations immediately before the funding comes is preferred

Many investors and venture capitalists do not like to invest in LLCs. Investing in an LLC can create unintended consequences under Employee Retirement Income Security Act (ERISA) for pension funds who may have invested in the fund making the investment. Many investment funds are prohibited by their governing documents from investing in an LLC entity type business.

Venture capital and other funds do not want to wait for a portfolio company to finish its own tax return and issue K-1s to its members before the fund can do its tax return and issue its K-1s to its investors. There is a significant tax incentive to invest in “qualified small business” stock, requiring that the company receiving the investment be a C corporation.

There is no one-size-fits-all solution, we recommend that founders start their business as an LLC and convert to a C corporation immediately before receiving substantial outside funding.

This is general advice, and you should consult with your own attorney and accountant for the form of organization that best fits your business needs.

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Melissa Clark
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Melissa Clark

Head of Content & Customer Marketing at Incfile
Melissa sets the vision for Incfile's content marketing and customer relationship management. Melissa has more than 10 years experience in various marketing roles, and a passion for supporting small businesses as they incorporate and grow. She loves sharing information that will help business owners maximize their LLCs, Corporations and Nonprofits. In her spare time, Melissa is an active member of The Junior League and enjoys running half marathons.
Melissa Clark
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