So you want to launch your startup? You have a great idea, you assembled your team, you probably have a nice business plan, your parents and some close friends already promised to give you some seed funding, and maybe you even have a prototype. Now there is nothing left for you to do but go out there and do it, right? Wrong! This is my first blog post, so it seems appropriate to write about one of the first legal decisions a startup or small business has to make: what business structure should you choose?
This decision will have important tax and legal implications for your business, so don’t take it lightly. The 4 most common business structures are:
- Sole Proprietorship
- Limited Liability Corporation (LLC)
Some of these may also break down into additional sub-types, depending on the state you file in. Non-profit corporations and cooperatives are also common structures, but I will focus on thefor-profit business structures and leave those for a separate blog post.
Every business has different needs, so determining the right structure is going to depend on the specifics of your business. LLC’s have become very popular in recent years due to their combination of liability protection, pass-through taxation, and relatively simple formation, but there is no one-size-fits-all structure so think through this decision carefully. Before choosing a structure you should reflect on your business and it’s current and projected needs. Consider the following 4 factors:
- Formalities: each business structure will require you to comply with certain formalities to form and maintain your status. Some are extremely easy to form, like sole proprietorships or partnerships, while some, like corporations, require a lot of paperwork and lawyer’s fees to get done properly. Some structures require you to put agreements in place, hold annual meetings, or take a vote every time you want to do something. Naturally, structures with more intense formalities tend to confer additional benefits, so you have to consider the trade-off. How much time and money are you willing to spend in order to limit your personal liability, receive tax incentives, or improve your odds of receiving future investment?
- Liability: some business structures limit your personal liability for actions that the business takes, while other structures don’t limit your liability at all. Generally it’s good to have some level of protection because otherwise all of your personal assets will be at risk. This is especially true if your business will be operating in a high-risk industry that is often on the receiving end of a lot of lawsuits. If your business operates nationally or internationally in multiple jurisdictions, works with a variety of vendors, sells consumer products to a high number of end-user customers, or does something relatively dangerous, you will probably want more liability protection. If you just sell small figurines of cats wearing funny hats, you may be willing to settle for less protection.
- Taxes: some structures allow pass through taxation, while some require double taxation.
- Investment: are you providing all of the money for this business, or do you have investors? Are these investors also making management decisions? Will you be seeking additional investment in the future? Do you want to go public someday? Identify your growth plan and the type and frequency of investment you will need to get there, and choose your business structure accordingly.
A sole proprietorship is a one-person business. You own it, you keep all the profit, you shoulder all the debt, and you take on all the liability. The formalities are very simple: you don’t have to file with the state and you don’t really have to do anything to maintain your status, you just start doing business and BINGO BANGO you are a sole proprietorship. This means that there is no separate legal entity, the business and owner are one-and-the-same.
Since the business is not a separate entity, it gets “pass-through” taxation, meaning the company doesn’t need to file a separate tax return because the profits “pass through” the company to the owners and the owner simply files profits and losses on their personal return with a Schedule C and Schedule SE (self employment taxes) along with their 1040. The big downside of this structure is the liability protection because, well, you don’t get any. You are personally liable for all business debts, s0 if your company gets sued and loses then all your personal assets can be used to pay for the court judgment.
One important point: if you decide to do business as a sole proprietorship, the default legal business name is your personal name. Any other name you use is a DBA (doing business as) name (also known is some states as an “assumed business name” or “trade name”). Keep in mind that simply doing business under a DBA still doesn’t actually create a separate legal entity. If you are a sole proprietorship the business is just YOU, regardless of any other name you use. Since this can sometimes be confusing to consumers, many states require or encourage businesses to file a DBA statement. For example, although it is not required in Arizona, you can file a trade name with the Secretary of State by submitting a simple application along with a $10 fee. This is often necessary anyway because many banks require sole proprietorships to have a registered dba before they can open a bank account.
When people talk about partnerships they are usually referring to a “general partnership”. In many ways a general partnership is the same as a sole proprietorship, except you get to share the ride with a partner. A partnership is formed when two or more people go into business together, and like a sole proprietorship you don’t have to file anything with the state or maintain any formalities to retain your partnership status, you enjoy pass-through taxation, and all partners are personally liable for the debts and obligations of the business.
When filing taxes, each partner simply reports profits from the partnership on their individual tax return and also file a Schedule K-1 form to indicate their share of the partnership income. Despite not paying any income tax, the partnership itself must still compute and report its income to the IRS on a Form 1065. The added costs associated with these accounting requirements make partnerships more costly than sole proprietorships.
Partners can, and should, enter into a written agreement outlining the rules that govern the partnership, including things like ownership shares, rights, duties, what happens if a partner leaves or the business folds, etc. Without such an agreement, the laws in your state will govern your partnership. Most states have adopted some version of the “Uniform Partnership Act” or “Revised Uniform Partnership Act“, and under these rules each partner shares equally in the profits and has “agency authority” for the partnership (meaning they can individually make management decisions and enter into contracts that bind the whole business). Similarly, each partner is fully liable for the business debts and obligations of the partnership. Yes, you heard me right. If the partnership is in debt, each individual partner is fully liable for the whole amount until the debt is paid. If one partner skips town and can’t be located, the remaining partners still have to settle the full amount of the debt. These laws are meant to be one-size-fits-all and thus won’t always be able to adequately address the issues specific to your business, so it is almost always better to draft an agreement that clearly lays out the rules for your partnership.
A limited partnership has two classes of partner: a general partner and a limited partner. The general partners have all the same rights and duties of partners in a general partnership. A limited partner, however, is the classic “silent” partner whose sole contribution is money. Limited partners’ liability is limited to their monetary investment, meaning that their personal assets cannot be used to pay off business debts, but they are not allowed to interfere with the management of the business. Limited partners need to be careful to stick to their passive role, because if they start acting like a general partner and making management decisions they may lose their limited liability. However, some states have carved out exceptions that allow limited partners to vote on certain fundamental decisions without losing their limited liability.
Limited partnerships are a more attractive business structure for investment purposes because they allows investors to be involved without the same risk normally associated with a partnership. The drawback is that limited partnerships require more formalities, as limited partnerships need to file formation documents with the state, and limited partnership interests are often subject to complex securities laws.
Limited Liability Partnership
Limited liability partnerships are similar to a general partnership except they grant a level of limited personal liability to EACH partner, regardless of that partner’s management role. Some states only allow LLP’s for certain types of professional organizations, and some states only offer limited liability to partners for certain types of claims against their business. LLP’s are most popular among professionals, like law firms and accountants, that don’t want to be liable for the professional malpractice of their partners.
Limited Liability Limited Partnership
A LLLP is a version of a limited partnership that grants limited liability to both general partners and limited partners. So LLLP’s still have a general partner with the the right to manage the business but who also has limited liability, and they have passive limited partners who do not participate in the management and have limited liability. LLLP’s are subject to similar formalities as LP’s, they enjoy pass through taxation, all while providing added liability protection. LLLP’s are a relatively new concept and are not recognized in every state (they are recognized in Arizona pursuant to A.R.S. § 29-1101, et seq.). LLLP’s are most common in the real estate business.
A corporation is a separate legal entity owned by a group of shareholders (owners). Corporations are great investment vehicles, protect owners from liability, and are eligible for the corporate tax rate (which is usually lower than the personal income tax rate). The drawback is that corporations are much more time consuming and costly to start and operate, and are often subject to double taxation. This structure is general better for larger, more complex businesses, or any startup companies (I’m lookin’ at you Silicon Valley) that will seek venture capital or eventually try to go public.
Regular corporations are often referred to as “C” corporations because they are subject to Chapter 1 Subchapter C of the IRS code. Under this code many corporations have to pay taxes twice: first, as a separate legal entity, corporations have to pay federal and state corporate income taxes, and second, shareholders have to pay taxes on their personal return when the corporation pay them dividends. However, corporations often have access to other tax strategies that can be advantageous. For example, if shareholders are also employees then corporate earnings can be paid out to them in the form of salaries, so long as those salaries are considered “reasonable” by the IRS, and is then only taxed once at the personal income tax rate. Corporations also make it easier to access capital by issuing and selling ownership shares, making corporations the most attractive structure for investors. It also helps to retain valuable employees through the issuance of employee stock options.
The major drawback of corporations, in addition to double taxation, is the cost associated with filing and maintaining corporate status. Registration requires certain filings with the state government, usually Articles of Incorporation, and sometimes the issuance of stock certificates to initial shareholders and a vote on corporate bylaws. The corporation also needs to observe certain formalities, such as regular board and shareholder meetings, meeting minutes, board votes on important decisions, keeping personal assets separate from company assets, and detailed record-keeping. Corporations are further subjected to increased obligations and regulatory scrutiny if they are publicly traded. If a corporation fails to adhere to the laws imposed by state and federal regulatory bodies or its own bylaws, then a corporate could strip the company of it’s status as a corporation and make shareholder personally liable for the company’s business debts.
S Corporations are essentially regular corporations that have filed for a Subchapter S designation with the IRS. They are subject to all of the same costly and time consuming formalities as C corporations, and they also provide the same limitation on personal liability for shareholders. However, only companies with 100 shareholders or less are eligible for the Subchapter S designation with the IRS, so this business structure is generally preferred by smaller businesses. Also, certain types of corporations, such as insurance businesses and financial institutions may be ineligible.
The primary difference between an S corp and a regular corporation is that S corporations enjoy the pass-through taxation normally reserved for sole proprietorships and partnerships. The trade-off, however, is that S corps are not able to issue different types of stock (only “common” stock), which makes it a much less desirable structure for businesses that want to raise investment capital. Additionally, S corp stock can only be owned by certain types of owners – individuals, estates, and trusts – which can further hamper its ability to raise capital.
LIMITED LIABILITY CORPORATION
Finally, my personal favorite, the LLC. I know, I know, it’s weird to have a favorite business structure, but I do, and this is it. LLC’s are a relatively recent creation and have become extremely popular structures for any small businesses or really any company that is not seeking venture capital. LLC’s are essentially a hybrid between partnerships and corporations that include all the good stuff like limited liability and pass-through taxation, much like an S corp, except unlike an S corp LLC’s are not limited to 100 shareholders. You can also have single owner LLC’s, so these are great alternatives to a sole proprietorship if you are willing to satisfy the relatively simple formalities.
First, LLC’s give shareholders limited personal liability, just like a corporation. As explored previously, limiting your personal liability for debts of the business is extremely desirable. Second, like partnerships or sole proprietorships, LLC’s are not treated as separate taxable entities and thus profits and losses are passed through to the shareholders and declared on their personal income tax return. Third, while LLC’s are certainly not as good as corporations when seeking investment capital, you can elect to have a “manager managed” LLC, meaning that only the members designated as managers are responsible for the day-to-day decision making while the other members are “silent”. This makes it a little easier to bring in investors early on that don’t actually want to run the company.
Fourth, LLC’s are much easier to form and maintain than corporations. You simply file articles of organization with your local corporation commission (find AZ’s HERE) along with the filing fee ($50 in AZ) and any other documents your state requires. You are also usually required to fulfill a publication requirement by publishing a notice of your LLC’s formation in a local paper, but after that you’re done. Although I would generally recommend hiring an attorney to help you through this process, it is something that you can often do yourself. As explored above, you do need to maintain some formalities, but they aren’t as rigorous or costly as corporations (no board of directors). You should also create an operating agreement, much like you would for a partnership, that sets out the rules governing the LLC. Otherwise, the default rules of your state will apply, which may be undesirable because these rules generally require profits to be divided equally between members, the LLC to dissolve after even a single member leaves or dies, or other things that may not be what you want. Operating agreements can also else help establish and maintain your LLC status, as it is evidence that you are treating the business as a company separate from your personal self.
Once you have an idea about what type of structure you think is best for your business, I would recommend at least briefly consulting an attorney to solidify your plan, to make sure you haven’t missed anything, and to help you through some of the more complicated steps. I love to help companies through the formation stage so that they can get to the more exciting task of running their business, so call my office or send me an email to discuss your needs.
Disclaimer: This blog is not legal advice and is only for general, non-specific informational purposes. It is not intended to cover all the issues related to the topic discussed. If you have a legal matter, the specific facts that apply to you may require legal knowledge not addressed by this blog. If you need legal advice, consult with a lawyer.