Entrepreneurs can quickly become overwhelmed by the many actions required to establish their new venture as a legal entity that meets all local and federal regulations. In many countries, the regulatory hurdles can be a barrier to entry in their own right. While there are several actions to take when starting a new company, I want to focus on your options for structuring the startup as a legal entity.
Important Starting Point: Soliciting guidance from a lawyer and an accountant is advisable. While there are certain activities, you might be able to accomplish on your own, having expert advice ensures you avoid significant mistakes that may impact future personal and financial circumstances.
As a founder with much on the plate and limited resources, you may ask, do I have to incorporate at all? The answer depends on the status of the venture. You probably can wait in the earliest concept state where you are considering the opportunity. One of the earliest triggers is taking on a co-founder or partner. Even in the earliest stages, this is an essential step with several legal consequences. At this point, I suggest you seek advice from a lawyer, focusing on incorporation and partnership agreements at a minimum. Other critical milestones include hiring employees or independent contractors, the need to protect intellectual property, opportunities for grants or early investments, and, of course, once you are ready for customer transactions. Most of these critical moments require that the startup be a separate legal entity from individual founders.
There are a couple of immediate benefits to incorporating at this stage. First, founders limit their liability against several potential issues. For example, if the company fails to make money and goes bankrupt, the legal responsibility to pay back debts is on the company and not the founders as individuals. As a founder, you don’t want to jeopardize your finances and assets if the enterprise fails. A second immediate benefit is a capacity to offer shares in the company. While different types of incorporation have various restrictions, the non-incorporated venture cannot share ownership in the form of shares. Without this ability, you cannot attract outside investors. In general, before incorporating, founders are limited in what they can do and how they can operate.
With that in mind, the legal structure you choose for your new venture will impact registration requirements, taxes, and personal liability. Each legal structure has its advantages and disadvantages, and your decision will depend on your enterprise’s short- and long-term goals. Founders must carefully consider the legal form of their business to ensure that the form chosen best meets the short-term and long-term requirements and the significant tax and non-tax differences. Most importantly, the various legal entities have substantial tax and non-tax differences. So it is vital to consider the differences and the impact on personal and company finances.
Spoiler Alert: Before describing the different types of structuring options, if you are a startup founder (and don’t want to read the whole post), the most common choice for most startup situations is limited liability corporation (LLC) versus a “C-Corporation.” If you jump to those two sections, you can consider the advantages and disadvantages of each. If you plan to operate a closely held, small business, and do not plan to seek substantial outside investors, then an LLC may be your best choice. An LLC structure provides the liability protection founders need with tax advantages and governance flexibility. On the other hand, if you have plans to actively solicit external funding from investors and issue various stock classes to co-founders, employees, and investors, then the C-Corporation is the best choice.
With all this in mind, let’s look at the various structuring options for startup founders. Entrepreneurs have several legal forms of business to choose from, including sole proprietorship, partnerships, LLC, C-corporation, S-corporation, and B-corporation. Entrepreneurs should determine which business form is best for their short-yerm and long-term needs. In choosing a form of ownership, entrepreneurs must remember that there is no single “best” form; what is best depends on the individual’s circumstances.
Sole Proprietorship
A sole proprietorship is a form of business in which a single owner does business themselves and requires only that the company registers with the local State government entity. Sometimes, a business or sales license is also required, and founders should check on regulations. If the proprietorship is to do business under a trade name, a Certificate of Doing business under an Assumed Name must be filed with the State and county where the company will operate. The fee for filing the certificate is usually nominal. Acquiring this certificate involves conducting a name search to determine that the term used is not already registered as the name of another business or as a trademark or service mark for another company.
The sole owner has the right to make all the decisions for the business. However, the owner is personally liable for all debts and contracts of the company. Because there is no distinction between personal and business debts, the creditors can sue to collect from the owner’s assets if the business cannot pay its bills. In matters dealing with taxes, profits, and losses, the business flow directly to the owner and is taxed at individual income tax rates on the owner’s tax return. If the owner does not plan to take a salary, income is the business’s profits.
Sole proprietorships are popular because they have two attractive features. First, one of the most attractive features of sole proprietorships is how fast and straightforward it is to begin operations. If a proprietor wishes to operate the business under their name, one obtains the necessary license(s), if any, and begins operations. In a sole proprietorship, the proprietor is the business. It is not difficult to start a proprietorship in a single day if the company is simple. Secondly, the proprietorship is generally the least expensive form of ownership. Typically, the proprietor goes to the appropriate State or county government office and states the nature of the new business in their license application. The government assesses the proper fees and license costs. Once these fees are paid, the owner is allowed to conduct business.
The bottom line is that sole proprietorship is not for everyone, as you see below under disadvantages. But if those disadvantages don’t concern you, it is a simple structure.
Advantages and Disadvantages
As a solo founder-owner, you have total decision-making authority. Because the sole proprietor is in complete control of operations and can respond quickly to changes, this becomes an asset in rapidly shifting markets. The freedom to set the company’s course of action is another primary motivation for selecting this ownership form. For the individual who thrives on the enjoyment of seeking new opportunities and modifies the business as needed, the free, unimpeded decision-making of the sole proprietorship is an enticing proposition.
Secondly, the proprietorship is the least regulated form of business ownership. There are minimum legal requirements and reporting obligations. Founders must ensure they provide local and federal governments with all proper tax reporting. When government requests for information seem never-ending, this feature has many merits.
Finally, all financial outcomes go to the founder-owner. The proceeds minus taxes go directly to the founder of your startup, which earns a profit. That said, you are personally liable for all debts and obligations, which is one of the significant disadvantages.
As advantageous as the sole proprietorship form of ownership is, it does have three major disadvantages:
The most significant disadvantage of a sole proprietorship is an unlimited personal liability; that is, the sole proprietor is personally liable for all business debts. The proprietor owns all the assets of the business. If the business fails, these assets can be sold to cover debts. If unpaid debts exist, creditors can seize and sell the owner’s assets to cover the remaining debts. Failure of the Business can ruin the owner financially. Because the law views the proprietor and the business as the same, the business’s debts are the owner’s personal debts. Laws protecting an individual’s personal assets to some degree may vary from one State to another. Most states require creditors to leave the failed business owner a minimum amount of equity in a home, a car, and some personal items. The new Federal Bankruptcy Law protects retirement assets from creditors. Bankruptcy may be needed to protect a failed business owner. Because laws vary, picking the proper jurisdiction in which to do business is critical.
A sole proprietor generally needs financial resources for a business to grow and expand. Many proprietors put all they have into their companies and often use their personal resources as collateral on existing loans. In short, unless they have great personal wealth, proprietors find it difficult to raise additional money while maintaining sole ownership. The business may be sound in the long run, but short-term cash flow difficulties can cause financial headaches. Most banks and lending institutions have well-defined formulas for borrower eligibility. As a result, a proprietor may not be able to obtain the funds needed to operate the business, especially in difficult times.
Lack of continuity is inherent in a sole proprietorship. If the proprietor dies or becomes incapacitated, the business automatically terminates. Unless a family member or employee can effectively take over, the company’s existence could be jeopardized. In some circumstances, creditors can petition the courts to liquidate the dissolved company’s assets and the proprietor’s estate to pay outstanding debts.
Partnerships
A partnership is an association of two or more people as co-owners of a business for profit. There are typically two types of partnerships. The first type, a general partnership, requires that each partner participates in all profits and losses equally or to some previously agreed upon ratio. Typically, a general partner has unlimited liability, which includes personally owned assets outside the business association. A partnership can be created either by a formal agreement or an oral understanding (though I don’t recommend the latter). In addition, it must be banded together for profit-producing motives and is generally not considered a legal entity separate from the partners. A general partnership may not sue or be sued in the firm’s name. Each partner shares potential “joint and several” liabilities. The second type of partnership, a limited partnership, limits the liability of the partners to the extent of their capital contributions. A limited partnership must have at least one general partner, so at least one person or entity’s personal assets must be at stake. In many instances, the general partner is a corporation, so only the corporate assets are at stake.
Advantages and Disadvantages
Like the sole proprietorship, the general partnership is easy and inexpensive to establish. The partners must obtain the necessary business license and submit a few forms. In most states, partners must file a Certificate for Conducting Business as Partners if the business operates under a trade name. Limited partnerships require registration to be official.
There are no restrictions on how to distribute profits as long as they are consistent with the partnership agreement and do not violate the rights of any partner. For this reason, a legal partnership agreement must exist that outlines how profits, benefits, and assets are divided. Secondly, partnerships have access to a larger pool of capital. The partnership form of ownership can significantly broaden the pool of capital available to the business. Each partner’s asset base improves the ability of the company to borrow needed funds. Therefore, each individual has more to contribute to equity capital, and their personal assets will support a larger borrowing capacity. Additionally, a partnership can attract investors who, with limited liability, can still realize a substantial investment return if the business is thriving. Many individuals find investing as limited partners in high potential small companies very profitable.
Finally, a partnership itself is not subject to federal taxation. Its net income is distributed directly to the partners as personal income, on which they pay taxes. General partners are allowed to use partnership losses on their individual returns. The partnership, like the sole proprietorship, avoids the double taxation applicable to the corporate form of ownership.
The major disadvantage of a partnership structure is that at least one partner must bear the brunt of unlimited liability. At least one member of every partnership must be a general partner. The general partner has unlimited personal liability. Most general partners play an active role in the company’s operations. Often, one or more general partners will be designated as managing partners. General partners act on behalf of the company regarding legal and financial considerations. However, they also have unlimited liability. So if the company acquires debt or other liability, it passes through the general partners. If you set the structure up as a limited partnership, then only one owner is designated as a general partner, and they alone have unlimited liability.
Secondly, although the partnership is superior to the proprietorship in attracting capital, it is generally not as effective as the corporate form of ownership. This condition exists because the partnership usually has limitations and restrictions to raising capital.
As stated earlier, partnership agreements must detail all financial and operational responsibilities among all partners. Friction among partners is inevitable and difficult to control. Disagreements over what should be done or what was done have dissolved many a partnership. One of the areas of potential conflict resides in the restrictions on disposing of one’s shares in a partnership. Most partnership agreements restrict how partners can dispose of their business shares. It is common to find that partners must sell their interests to the remaining partners. But even if the original agreement contains such a requirement and delineates how to determine the current value, there is no guarantee that the other partner(s) will have the financial resources to buy the seller’s interest. When the money is unavailable to purchase a partner’s interest, the other partner(s) may be forced to either accept a new partner who purchases the partner’s interest or dissolve the partnership, distribute the remaining assets, and begin again. The partnership automatically dissolves when a general partner dies, becomes incompetent, or withdraws from the business, although it may not terminate. Even when there are numerous partners, if one wishes to disassociate their name from the company, the remaining partners will probably form a new partnership.
Limited Liability Company
An LLC is a blend of some of the best characteristics of corporations, partnerships, and sole proprietorships. First, it is a separate legal entity like a corporation. Second, it can be treated as either a sole proprietorship or a partnership for tax purposes, depending on whether there are one or more members. Therefore, it carries with it the “flow-through” or “transparent” tax benefits that corporations do not have. Third, it is very flexible and straightforward to run. As long as the terms of the operating agreement are adhered to, the LLC may be operated more like a sole proprietorship or a partnership than a corporation. The owners are called members, individuals (residents or foreigners), corporations, other LLCs, trusts, pension plans, etc.
An LLC is formed by filing an Article of Organization form with a secretary of State and signing an LLC operating agreement. Most states require that an annual report be filed to keep them apprised of the current status of an LLC. The LLC is not a tax‐paying entity. Instead, profits, losses, and the like flow directly through and are reported on the individual member’s tax returns unless the members make an election to be taxed as a corporation.
Advantages and Disadvantages
As noted above, the LLC has several advantages. First, formation is relatively straightforward. Owners are considered members and file with the local state government articles of organization. Formation does not require filing corporate documents, appointing a board of directors, or distributing stock. Owners have quite a bit of flexibility in running the business, with minimum regulation.
Secondly, the LLC provides owners with limited liability protection against most business debts and obligations. In case of a lawsuit, only the business assets are at risk. Owners’ personal assets, such as bank accounts and real estate, are protected.
One of the significant advantages of this legal form is how profits and taxes are handled. All profits or losses are attributed to the owners. What is sometimes called a “pass-through,” as profits and losses are directly reported on the owner’s personal tax returns. The LLC owners use a Schedule C to report all profits, losses, and deductions on their individual IRS tax returns. If there are multiple owners, each files their returns separately. When there are numerous owners, they can also choose to be taxed as a corporation.
Compared to a corporation, the most significant disadvantage of an LLC is the difficulty securing outside financing. LLCs cannot issue stock to outside investors, thus making it challenging to entice investors and limiting future exit strategies. Additionally, it is impossible to grant stock options to managers and employees as one can in a corporation.
While there are no restrictions on the number or class of LLC members, transferring ownership is restricted. Requirements are different per local government regulations. Again, this situation may hinder specific exit strategies.
C-Corporation
The C-corporation is a common form of business ownership, especially for companies that are growing and raising funds. Publicly traded companies used this format. A corporation is a separate legal entity from its owners and may engage in business, issue contracts, sue and be sued, and pay taxes. The owners of a corporation hold stock in the corporation. Each share of stock represents a percentage of ownership. Directors and officers conduct the actual business.
When a corporation is founded, it accepts the regulations and restrictions of the State in which it is incorporated. It also accepts the rules and conditions of every State where it conducts business. When they conduct business in another state, that State considers their foreign corporations. Corporations formed in other countries but do business in the United States are foreign corporations. How a company incorporates impacts its ability to operate and tax liability. Also, a corporation may be taxed in every jurisdiction where it is incorporated or doing business.
Generally, the corporation must annually file in its State of incorporation and in every State where it is doing business. These reports become public records. If the corporation’s stock is sold in more than one State, the corporation must comply with federal and State regulations governing the sale of corporate securities. For most small businesses, selling stock will not involve registering the stock as a security. However, the law may require filing reports showing a registration exemption.
A corporation has three primary sections: the stockholders, the board of directors, and the officers. Therefore, it is essential to understand the specific functions of each section.
Advantages and Disadvantages
The corporation allows investors to limit their liability to the total amount of their investment in the corporation. They must adhere to the terms of the Certificate of Incorporation and bylaws. A corporation cannot just be set up and run as if it were a sole proprietorship. The officers must conduct business in the name of the board of directors. Using books and records separate from those of the shareholders. This legal protection of personal assets beyond the business is of critical concern to many potential investors. Because startup companies are risky, lenders and other creditors often require the owners to personally guarantee loans made to the corporation. By making these guarantees, owners are putting their personal assets at risk (just as in a sole proprietorship), despite choosing the corporate form of ownership. However, limiting the scope of a guarantee is possible, so not all personal assets may be at risk.
Based on the protection of limited liability, the corporation has proved to be the most effective form of ownership to accumulate large amounts of capital. Limited by only the number of shares authorized in its charter (which can be amended) and subject to the laws on registration of securities, the corporation can raise money to begin a business and expand as opportunity dictates. Professional or “institutional” investors such as venture capitalists demand this form of incorporation.
Unless limited by its charter, the corporation as a separate legal entity theoretically can continue indefinitely. The existence of the corporation does not depend on any single individual. Additionally, suppose stockholders in a corporation are displeased with the progress of the business. In that case, they can sell their shares to another individual, subject only to restrictions on the transfer of shares. Stocks can be transferred through inheritance to a new generation of owners. If any person wishes to own shares in a firm and there is someone who would like to sell their interest in that firm, an exchange is possible. During all this change of ownership, the business continues.
There are two main disadvantages of C-Corporations. First, corporations can be costly and time-consuming to establish. In some states, an attorney must handle the incorporation, but in most cases, entrepreneurs can complete the requirements. However, suppose an entrepreneur is concerned about the complexity of the requirements. In that case, they may feel more comfortable employing an attorney even in states where one is not required, so one does not go afoul of the legal and registration requirements. Failure to properly register and follow the corporate form may cause a loss of the ability to limit shareholder liability.
For federal tax purposes, corporation profits are taxed and reported on the corporation tax return. Current federal rates range up to 21 percent due to 2017 tax cuts. Any after-tax profits distributed to shareholders as dividends are taxed again and are reported by the shareholders on their personal tax returns. This condition is commonly referred to as double taxation.
S-Corporation
The S-corporation often referred to as a sub-S-corporation, is a corporation that elects under federal and State tax laws to be taxed like a partnership. Its profits and losses are recognized for tax purposes at the individual shareholder level. It is the shareholder’s responsibility to report the profits or losses on their individual income tax returns. This type of corporation works well for startups or small companies that anticipate net losses for a substantial period. In this case, the owner can use the loss to offset other income, or the owner is personally in a lower tax bracket than the corporation, thus saving money in the long run.
Several restrictions are inherent in this type of corporate entity, which makes it challenging to entice external financing. For example, S-Corporations can only issue one class of stock to individuals and certain trusts. In addition, the number of shareholders is limited to one hundred maximum.
Advantages and Disadvantages
The S-corporation retains all the advantages of a regular corporation, such as continuity of existence, transferability of ownership, and limited personal liability. However, the most notable provision of the S-corporation is that it avoids the corporate income tax (and the resulting double taxation) and enables the business to pass operating profits or losses on to shareholders. In effect, the tax status of an S-corporation is similar to that of a sole proprietorship or partnership.
S‐corporations have restrictions on the use of losses and tax recognition on sales of their assets different from those of a C-corporation. These may be disadvantages to the owners. Thus, although one may face double taxation as a C-corporation, the loss of flexibility on the sale of assets or stock of the corporation may require one to remain a C-corporation and ultimately gain the most profit upon the sale of a business. In addition, if the entrepreneur intends to raise capital from third parties, such as venture capitalists, the company will have to be restructured into a C-corporation before this can occur.
Benefit Corporation
A recent addition to the founders’ choices for incorporation is a Benefit Corporation, not to be confused with a “B-Corporation,” which is an awarded certification based on an assessment by a non-profit called B-Lab. Benefit corporations are State registered and operate for profit but emphasize social and environmental impact.
A Benefit Corporation differs from a traditional corporation because it has a broader perspective by expanding the concepts of purpose, governance, transparency, and accountability concerning a more comprehensive range of stakeholders beyond standard stockholders. For example, benefit corporations must commit to producing a general public benefit and operating responsibly and sustainably in addition to financial performance. In other words, social impact objectives must be as important as economic outcomes. In addition, from a governance perspective, a board of directors must consider the interests of a wide range of stakeholders, including supply chain partners, employees, local communities, and the environment. Finally, social impact and financial performance must be communicated to all shareholders and the public.
Advantages and Disadvantages
The Benefit Corporation has many of the same advantages as other corporations. First, these entities are taxed similarly to other for-profit organizations. There is no separate IRS classification for a benefit corporation. As a benefit corporation, owners can elect to be taxed as either a C-corporation or an S-corporation.
B corporations, like other corporations, have limited liability protection, which sometimes extends to cover any shareholder lawsuits for failure to meet social impacts. With all that said, Benefit Corporations still are at risk of shareholder lawsuits in some states. Thirdly, there may be a brand benefit to being seen as a company that pursues profits and social good. While far from proven, many stakeholders, including customers, employees, and investors, find B Corporations attractive.
As of 2022, over 30 US states offer benefit corporation status. It is still early to tell if such designations improve a venture’s brand reputation, financial performance, or social impact. Advocates believe that customers tend to purchase from a company recognized as having a social mission over one that does not. These outcomes are far from proven, but there are still many ethical and business reasons to opt to meet higher standards of social and environmental performance, transparency, and legal accountability.
Conclusion
There are many legal steps that startups need to take as they move toward launch. Deciding on what legal form the business takes depends on personal and business goals. As one considers what is best for them and their venture, be sure to engage the services of a legal professional. In the realm of costs, the expense of incorporation is much less than the potential legal and financial ramifications of making the wrong choice.
Get a copy of Patterns of Entrepreneurship Management, 6th Edition, for more on this subject and other entrepreneurship topics.
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