What is the Best Business Entity for Your Startup?

One recurring question entrepreneurs often ask is: What business entity structure is best for my startup? Like most legal issues, it depends on numerous factors, such as the nature of your business, the number of founders, your goals, etc. There is no single best business entity choice for all startups or even all startups engaged in the same industry.

To help guide you in choosing the best entity structure for your startup, here are most common types of business entity structures.

Startup Business Entities

1. Sole Proprietorship

A Sole Proprietorship is the default business structure. Nevada defines a Sole Proprietorship as: “any natural person who owns and operates a business where there is no legal distinction between the owner and the business. The owner receives all profits and has unlimited responsibility for all losses and debts.”

Essentially, there is no legal distinction between a Sole Proprietorship and the owner of the business. Therefore, the owner is personally liable for the business’s obligations and the business cannot live on past the death of the owner. All profits and losses flow through directly to the owner.

The only notable advantage of a Sole Proprietorship is its simplicity. Conversely, there are significant disadvantages that come with co-mingling personal and professional liability.

Sole Proprietors are legally responsible for all liabilities the business incurs. Therefore, short of bankruptcy, these liabilities could follow you for life.

Some Sole Proprietors choose to file a DBA which just means “doing business as.” The reasons for using a DBA are typically related to marketing rather than any structural business purpose. The DBA is simply an alias that puts a professional facade on your Sole proprietorship. Consequently, it does not personally shield the owner from liability in any way.

2. Partnership

If you need help running your startup, you might consider a Partnership. Partnerships operate similar to sole proprietorships. Thus, there is little formality required to form a Partnership and no legal distinction between the Partnership and the owners.

The owners usually enter into some sort of formal partnership agreement. However, it may not require a filing in most states. Nevada defines a General Partnership as: “An unincorporated company formed by two or more persons. Owners are personally liable for any legal actions and debts the company may face.”

Partnerships are simple to start and operate. moreover, a partnership provides the added benefit of allowing the partners to raise money by selling partnership interests.

In Nevada, you will be personally liable for the General Partnership. In other states, there may still be a fuzzy line between personal and business finances. Consequently, it is not wise to ever assume limited liability within a Partnership. There could also be some potential confusion around partner roles, responsibilities, and liabilities depending on the depth of the Partnership agreement.

3. Limited partnership

A Limited Partnership (“LP”) is a variation of a partnership. Therefore, it is generally similar to a partnership. As the name suggests, the limited partners have limited liability. The general partners act as partners would in a partnership and have the same liability as outlined above.

In the case of an LP, the general partners are responsible for managing the everyday business. The limited partners act as investors who can only purchase limited partnership interests. If limited partners act as general partners, the IRS and courts will treat them as such for liability purposes. Therefore, it help to think of limited partners as true “silent partners.”

This structure is popular in certain industries such as finance (Hedge Funds, VC Funds, etc.), film, real estate development, and oil and gas exploration. This is because LPs can be used for the limited duration of the project and end with a distribution.

On one hand, having a Limited Partnership legally requires the general partners to keep their hands out of the operations. However, entrepreneurs might not be fans of this structure because there’s no built-in protection for them.

4. Limited Liability Companies (LLC)

Limited Liability Companies (LLC) provide a hybrid legal structure. It offers pass-through tax like a partnership and the limited liability offered to shareholders of a corporation by formally segregating personal assets from company assets. An LLC is formed by filing articles of organization with the State. LLCs do not have to have boards, hold annual meetings, or record minutes like Corporations.

In an LLC, there is no limit to the number of member. Additionally, ownership can be broken down into different classes. This gives entrepreneurs some flexibility when it comes to raising equity financing and retaining control of voting rights. This structure can make sense if your company is at the stage where it might attract friends and family or angel investors. For various reasons, it is often the case that VC firms prefer purchasing stock in a corporation over purchasing membership interests.

5. C Corporation

A Corporation is a legal entity that is distinct from its owners. It can only be created by filing specific documents with the state. The owners of the corporation are shareholders and are generally not personally liable for the obligations of the corporation. Unlike partnerships, only the corporation can be liable for genuine corporate obligations.

The board of directors often manages the company. The board delegates the day-to-day management obligations further. Ownership interests are freely transferable and the corporation has perpetual existence. C Corps have double taxation. C Corps are taxed at the corporate level and shareholders also pay taxes on dividends. However, this is not an issue for many early-stage startups that are more focused on growth.

If you are an early-stage startup that has its sights set on venture capital, opting for a C corp often makes sense.

6. S Corporation

Tax laws allow certain Corporations to elect to be taxed as partnerships. S Corps are pass-through entities that take advantage of Subchapter S of the Internal Revenue Code. This allows S Corps. to avoid taxation of corporate income. Therefore, the profits and losses flow through to the owners like a partnership.

S Corps have a number of relevant restrictions. (1) There can only be one class of stock. (2) There cannot be more than 100 shareholders. (3) Each of the shareholders must be an individual.

An S Corp is a good option for you if you want to limit the number of shareholders and need liability protection. S corps are not ideal if your goal is to seek venture capital because you’re limited to one class of stock, which eliminates your ability to do multiple financings.

Changes in corporate structure are often permissible. However, it is often helpful to seek professional advice to figure out which business entity structure suits your business goals.

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