When starting a business, one of the first things you need to think about is legal structure. So, there are several options and we are going to help you decide which is best for you. Usually, I recommend that you first start out as a limited liability company (LLC). Later you can plan to convert to a C corporation. But, before I get into all that – I want to talk to you about your options.
My mother’s business when I was a kid was a sole proprietorship. Most would agree that this is the easiest type of business to organize. All you really need to do is apply for the required licenses. A lot of people choose this because of tax reasons. For tax reporting just report the company’s income and expenses on a form that you will attach to your annual tax return. That’s it! But, from personal experience, I can tell you it isn’t 100% the best choice for everyone. The bad news is – as a sole proprietor you are 100% liable for all the company’s debts. This could be anything from vendors, taxes, payroll, and loans.
So, you really aren’t better off going this route for long. To start out with – sure. But it’s not a good place to live. We recommend choosing one of these other options for the long term.
Everyone knows this one. A corporation is a company or group of people authorized to act as a single entity (legally a person) and recognized as such in law. What this has on a sole-proprietorship is that a corporation can provide protection to a founder against the liabilities of the company. For example, bank accounts, personal expenses, etc. But you have to also think about this – there are two kinds of corps.
The first one is – a Subchapter S (S Corporation) is a form of corporation that meets specific Internal Revenue Code requirements, giving a corporation with 100 shareholders or less the benefit of incorporation while being taxed as a partnership. An S corporation will not pay any federal corporate-level income taxes. The profits and losses of the corporation will be reported on the individual tax returns of the shareholders. You can only have 99 shareholders with an S Corp. And you cannot have limited partnerships and only one class of stock for economic allocations.
Next is a C corporation. A C corporation, under the United States federal income tax law, refers to any corporation that is taxed separately from its owners. A C corporation is distinguished from an S corporation, which generally is not taxed separately. It doesn’t have quite as many restrictions as an S Corp. Unlike with the S Corp – you are not limited to the number of shareholders you have. And you can have any number of classes of stock. But, choosing this option may result in double taxation of a corporation’s profits.
Limited Liability Company (LLC)
This is another one you might be familiar with. An LLC is a corporate structure whereby the members of the company cannot be held personally liable for the company’s debts or liabilities. (Great right?) Limited liability companies are pretty much hybrid entities that combine the characteristics of a corporation and a partnership or sole proprietorship. It is taxed like a partnership but provides the limited liability protection of a corporation, while still avoiding double taxation. This works well for those who will not seek venture capital or other substantial outside financing, however – if you do plan on seeking venture capital outside funding might want to go with C-Corp.
If you have to – start off as an LLC – and if it isn’t right for you I recommend changing over to one of the corporates I mentioned above as soon as you can. Do some consulting – talk to other business owners, an attorney, and/or your accountant about all of this. They can help you figure out which will fit you best.
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