You're excited to start a new business.
But which business entity is best for you?
These factors may help you decide.
So you have a great idea and are ready to start a new business? Congratulations! But exactly what type of business, legally speaking? A corporation? An LLC? A limited partnership? Sometimes it seems like there are as many legal business entity types as there are businesses!
Confused by the acronyms? Overwhelmed with the options? Don’t be: no matter your situation, there’s a perfect business entity for you. To figure it out, you first need to reflect on your personal circumstances. What matters most to you as a business owner? Below are some key considerations that can help you begin to evaluate which legal entity is the proper one for your business.
It's Not My Fault!
Limiting Personal Liability
How important is it to you that your legal liability for business activities is limited to the assets of the business? Are you willing to be personally liable for the business?
If, like most business founders, you are concerned with limiting your personal liability, then you should create a formal business entity to conduct operations. If you do business as an individual (even under a “d/b/a” fictitious name), then you can be held personally liable for the acts of your business.
By forming a business entity, you may able to shield yourself from personal legal liability for the conduct of the business. Not all entities offer equivalent limited liability, however; some offer limited liability for passive (financial) partners, with full personal liability for active (general) partners. Understanding the different ways liability limitation is handled will likely impact your choice of entity.
Pass-Through or Partnership?
Taxation & Reinvestment
Do you want your company’s profits to flow through to your personal tax return in their entirety? Or do you expect that your company will hold profits for reinvestment in its growth? Taxation options for your business will vary by entity type, with some allowing flow-through of profits and others requiring tax at the company level in addition to personal level income tax.
For example, corporations generally are subject to a “double tax”: the corporation pays tax on its income, and you as an owner pay tax on the dividends you receive. An exception is the subchapter-S corporation, which avoids the double tax scheme by allowing profits to flow through to the individual owners’ tax returns. However, sub-S corporations are subject to certain limitations, including limitations on the number and type of shareholders, and types of classes of stock, among other things.
Unlike C corporations, other entities (such as LLCs) offer flow-through of profits to the individual owners’ tax returns. Depending on your other goals for the company, including reinvestment of profits in the company and outside investment expectations, a traditional C corporation with higher taxation may be necessary; otherwise, more often than not, your startup will want to choose an entity with a lower tax burden.
Who's the Boss?
Management & Control
Will all business owners participate in management of your company? Or will you have passive investors? How will the managers’ duties and powers be governed? And how will future managers be added or replaced?
Different entities have default structures that employ particular management structures. Corporations, for example, have relatively fixed management structures, with defined roles for boards of directors and officers. Obligations and powers are divided among the groups clearly along traditional lines, with shareholders appointing directors who serve on a board. The board of directors sets general policy and provides high-level guidance and direction. The board of directors also appoints officers (such as Presidents/CEO, CFO, Secretary, etc.) with fixed duties who are responsible for carrying out the day-to-day operations of the company.
Other entities offer flexibility in determining an appropriate management structure for your particular business. LLCs can be governed by means set forth by the parties in the LLC’s operating agreement. There may be 1 individual or business that is responsible for management of the LLC, acting as its manager, or many managers acting in unison. The managerial powers may be broad or limited. There may be certain decisions that require particular approval of the different LLC members. With an LLC, the possibilities are nearly endless. The number, type, and duties of officers (if any) may be specified and customized.
How you (and any co-owners and investors) intend to manage your company will likely impact your choice of business entity. Setting up a business entity from the start will allow the parties to decide their roles in advance and greatly reduce the risk of disputes down the road.
Follow the Money!
Capital Sources & Investors
Every business needs funding to succeed. Undercapitalization of your startup can lead to business failure, even when your concept might be promising. You will need to understand realistically how much capital will be required to fund your new business. But you also must know where you intend to acquire such funds because your intended funding sources can impact your choice of business entity.
How do you envision raising capital? On your own? From nonpublic, unmarketed sources such as friends and family? From third party investors such as venture capital (VC) firms? Initial public offerings (IPOs) of stock? The type of investor you expect will directly impact your choice of business entity. Certain investor types will not invest in certain business entities.
For example, if you anticipate seeking institutional or VC financing right out of the gates and expect to proceed to an IPO for liquidity, you will likely want to consider using a corporation as your form of organization. An LLC cannot be taken public through IPO, which makes it a less desirable type of company for outside institutional/VC financing.
And what do your capital sources expect in return for their capital? Will they have some sort of control? A preferred return on their investment? Silent partnership with simple economic interests? All of these factors inform the decision as to the type of business entity that works best for your company. Certain business entities will not work for silent partners; others will not work for partners with preferred returns.
For example, a sub-S corporation cannot have more than one class of stock, so no preferred return structure is possible. If your investor wants a passive financial role with some sort of excess return on their investment, the sub-S structure will not be appropriate for you—more likely, an LLC structure will be required.
Understanding the type of capital source/investor you will rely on, and the expectations of that capital source/investor with respect to their level of control and return on investment will inform your final choice of entity.
How About Tomorrow?
Can’t I Just Figure It Out Later?
There are a lot of factors that go into picking your business entity, and it might seem like a headache to deal with them now. It’s probably not as exciting as figuring out your marketing strategy or designing your logo and website! But there are very good reasons why you should lay this foundation now, before your business gets under way.
First, if you are going to be taking on any significant risks—signing a lease, getting a loan, etc.—then you should be doing so via an entity. Setting up the entity in advance will allow you to minimize your personal exposure to risk and contain it within the business.
Second, if you are going to be setting up relationships now, it may be the case that those relationships and their attendant rights are really meant for the business to hold, not you personally. For example, you probably do not want to be personally hiring employees; if anything, the work employees do should belong to the business, not to you. Similarly, you should not be signing nondisclosure agreements personally because it is likely the business that you eventually want to benefit from the protections these agreements offer. Setting up these relationships, with their attendant rights and responsibilities, will not make sense if they are done with you personally first. You will likely need to redo all of the relationships at the time a business entity is later formed unless you can devise a strategy for transferring or assigning them.
Finally, if you expect to be calling on investors soon, you should get your legal structure in place first. Taking time in advance to plan for your capital sources will save you money down the road by preventing a situation where you need to attract an investor but first have to completely change your business structure at additional legal expense. Better to get things right the first time by setting up a business entity that will allow you to access the capital you need from the get-go.
About the Author
Alexander Liroff is the sole attorney at Liroff Law, where he works passionately to help businesses of all shapes and sizes accomplish their goals. Mr. Liroff is admitted to The Florida Bar (2009). For 7 years, Mr. Liroff has practiced corporate law, working for 1,000+ lawyer firms and small businesses alike. He has practiced law in-house and as outside counsel to small and medium-sized businesses. He has represented multinational corporations and mom-and-pop start-ups.
Mr. Liroff holds an undergraduate degree from Dartmouth College, a master’s of science form he London School of Economics, and a juris doctorate from the Columbia University School of Law. His areas of study have ranged from the esoteric (philosophy and political science) to the scientific (genetics and cell biology) to the practical (law).
You can email Mr. Liroff at firstname.lastname@example.org.