When starting a new business, one of the first decisions you’ll need to make is what kind of legal entity you want to register your business as. This is a required step before you can register your business with the state, receive a tax ID number, and obtain any applicable licenses or permits.
You should consider your choice carefully. Your personal liability in the business, the way you fund the business, the kind of taxes you pay, and the amount of legal work that goes into starting the business are all factors that are heavily influenced by the company structure you select.
The first step is to decide if you are building a small business or a startup. The difference between the two is primarily concerned with your intentions for the business.
Small businesses are defined by the SBA as a "for-profit business of any legal structure that is independently owned and operated and not nationally dominant in its field." This means that a small business intends to find and capitalize on a local or otherwise niche market with no aspirations to expand beyond that market. Common financing sources to get a small businesses off the ground include personal savings, bank and government backed loans, grants, and investment from family and friends.The person(s) starting the business usually maintains a majority ownership stake in the business through its lifetime.
Startups, on the other hand, are all about rapid growth. Startup founders want to create an impact that extends beyond a single, small market and disrupt their industry on a national or global level. This means startups begin small just like small businesses, but intend to grow as quickly as possible. VC firms and other professional investors are much more interested in investing in startups because successful startups can generate astronomical returns. Founders get diluted over time as they raise more capital and often end up not owning a majority stake if the venture is successful.
Once you know what kind of business you’re starting, you can evaluate the different types of legal entities in the right context. There are a few different choices to consider:
Sole proprietorships are very easy to form. In fact, you are not required to register your business at all, because you are automatically considered a sole proprietor if you conduct business by yourself and haven’t registered as a different type of entity.
As a sole proprietor, there is no separation between you as an individual and your business as an entity. They are one and the same in the eyes of the law, and you are personally liable for all of your business’s debts and legal obligations.
If you want to start a business with one or more other people, a partnership is the simplest option. A partnership has obvious practical benefits, such as allowing you to combine skills, resources, and knowledge. A partnership functions somewhat like a sole proprietorship, except liability for the business is split evenly between all partners. This is called a general partnership.
There are also limited partnerships, which divide partners into general partners and limited partners. General partners remain personally liable for the business’s affairs, but limited partners are liable only for their investment or slice of ownership and generally don’t play a large role in the management of the company.
An LLC is made up of members, or a group of owners, led by a managing member who is responsible for managing the business on a day-to-day level. Membership is typically limited to 100 members. At an LLC, taxes pass through the LLC and are instead filed by the members as personal income tax.
Like a limited partnership, an LLC provides protection against liability, but the difference is that an LLC protects all members from personal liability, not just some. This essentially means LLCs can provide the full liability protection of a corporation while avoiding corporate tax rates.
A corporation is considered an entirely separate entity from its owners. The corporation itself is subject to its own taxation and legal liability (just as if it were an individual) rather than its owners paying taxes and accepting liability on its behalf. For this reason, corporations provide the greatest possible amount of protection to their owners.
However, corporations are much more complicated and expensive to register than LLCs, and they require a great deal more diligence and paperwork to operate correctly. Corporations are also governed by unique tax laws. The two most common types of corporation tax classifications you will see are C corporations and S corporations.
A C corp is taxed at the corporate level, meaning the corporation as an entity pays taxes on its business income, subject to corporate tax rates.
An S corp is a pass-through entity, much like an LLC. This means the business’s income tax is passed along to the corporation's owners who pay it as personal income tax. This can be an advantage in some scenarios because corporate income tax rates are sometimes higher than personal income tax rates. Unlike an LLC, an S corp is not restricted to 100 members or shareholders.
When you’ve decided what kind of business you want to start and you understand the differences between each type of legal entity, you have enough information to make an informed decision about which legal entity best matches your business plan. Here are a few examples:
If your goal is to start a small business that you own by yourself with no plans to expand further, a sole proprietorship is all you need. Just be aware that you are fully liable for your business’s legal obligations.
General partnerships are the best choice for a group of owners who started the business by pooling their resources. It can also serve as an easy way for a group to try out a business idea before registering for a more formal classification, as long as everyone involved is willing to accept their share of the liability.
A limited partnership could also be a good option if one or more owners are contributing capital but will not be involved in the management of the business, and thus want their liability to be limited to their investment. If you plan to open your business in a high-risk industry, you might be better off registering as an LLC to protect everyone’s personal assets.
A C corp is the best type of legal entity for startups that aim at rapid growth and plan to achieve it by raising funds from investors. Very few VCs or angels are willing to invest in LLCs or S corps because that would expose them to pass-through taxes. C corps are taxed as distinct business entities, so inventors are only taxed on their own dividends. The most popular type of C corp is a Delaware C corp, because registering in Delaware comes with some additional advantages.
If your startup doesn’t plan to raise capital from investors, you could opt to register as an S corp or an LLC to avoid corporate taxes. However, the vast majority of startups require funding from investors and are therefore better off registering as a C corp.
Your choice of legal entity is no small matter. The decision can impact the taxes you pay, the way your business operates, and your personal level of risk for years to come. It’s important to analyze your options carefully and choose the type of business formation that provides you the appropriate protections and capabilities for your business goals.
If you’re still unsure about which type of legal entity to pick, consider consulting a relevant professional such as a lawyer or business advisor.
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