As a startup small business owner, one of the first legal decisions you must make is the formal business structure you will adopt for your company.
With several different types of business entities to choose from, it's important to understand the advantages and drawbacks associated with various options before you finalize your decision.
From a sheer simplicity standpoint, it's difficult to beat a sole proprietorship. Very little is required in the way of formal filings and you won't need to spend a ton of cash on legal fees to get up and running. At the opposite end of the spectrum, C corporations can be extremely complex entities with burdensome filing requirements, recordkeeping procedures and high setup fees.
Liability should be a major consideration when choosing a business entity for your startup. C corps, S corps and LLCs go farthest in protecting business owners from personal liability. Sole proprietorships and general partnerships, on the other hand, offer virtually no personal liability protection. As a sole proprietor or general partner, you are personally accountable for an unlimited amount of debts and liabilities incurred by your business.
Sole proprietorships, partnerships, S corps and LLCs are pass-through organizations, i.e. profits pass through the organization, flowing directly to the owners. The advantage is that earnings are only taxed once – unlike a C crop where earnings are taxed for both the corporation and individual shareholders.
Investment considerations play a role in determining the type of entity you select for your startup – some business structures are designed to facilitate outside investment, while others preclude the possibility of funding from venture capitalists and other investors. From an investment perspective, a C crop is the best structure for investors and will be necessary if you intend to pursue venture capital. S corps and limited partnerships can be utilized for other types of investors, but most investors shy away from sole proprietorships, general partnerships and LLCs.
S corps, limited partnerships and LLCs are hybrid entities that can offer the best of both worlds for entrepreneurs. For example, LLCs provide pass-through tax treatment as well as protection against personal liability. The downside is that LLCs are not attractive for investors. Likewise, S corps offer personal liability protection, pass-through tax treatment and can be converted to a C crop, but there are limitations on the number of shareholders who can participate in the organization. Although hybrids are attractive, be sure to evaluate each option to eliminate the potential for unanticipated consequences.