When putting together your new venture’s business plan, it’s crucial to decide what type of business entity will be best for your startup. Choosing the wrong type of business entity is one of the most common, and significant, legal mistakes that startups can make. Too often, many unprepared entrepreneurs may rush to launch their new business independently without first consulting an experienced startup attorney that can help guide them in the right direction. The right choice of business entity depends on the kind of venture and the organization’s primary goals.
Common Types Of Business Entities
The limited liability company (or LLC) is a popular choice for many new businesses. An LLC provides protection from personal liability, meaning you are generally not personally liable for any debts or liabilities associated with the LLC.
As an LLC, your new company will not be required to have a board of directors, hold annual meetings or deal with many of the corporate governance tasks that corporations have to handle. Many entrepreneurs appreciate the informal and flexible management structure, as it allows them to focus on running the business.
Ultimately, however, the LLC’s tax flexibility is often the primary reason many entrepreneurs choose this type of business entity. Most often, LLCs are taxed as “pass-through entities,” which means that the LLC’s profits and losses are passed through to the members, and taxed at the member level, rather than the LLC level. Single-member LLCs are no different than how you are taxed as a sole proprietor, and multi-member LLCs are taxed like partnerships. If the LLC has losses, those losses get passed through to the members, and can be used to offset other income and potentially lower members’ taxes.
LLCs are the most widely used type of business entity for most new businesses in the US – restaurants, dry cleaners, consulting firms, marketing firms, franchises, and other types of businesses that you encounter every day. However, if you are forming a tech startup that intends to raise venture capital investment, you will most likely need a C corporation.
A C corporation (a/k/a “corporation”) is usually the ideal type of business entity for tech startups, especially if you intend to pursue venture capital funding. Venture capital investors are generally only able to invest in corporations, particularly Delaware corporations, for a variety of reasons. Unlike LLCs, corporations require a more formal management structure, with a board of directors, officers, and the need to hold regular stockholder and director meetings.
Another attractive feature for tech startups is that, unlike LLCs, a corporation provides you with the ability to compensate your employees with stock options, so it offers more opportunities for your startup to create equity incentives for employees.
Corporations are not pass-through entities for tax purposes. A corporation must pay taxes on its profits, and then if the corporation pays dividends to shareholders, those shareholders will pay taxes on the dividends they receive. This is called double-taxation, and while it is often characterized as a reason why you should form an LLC, it is usually irrelevant for tech startups. Most tech startups won’t have any profits to tax in those early years, and it is common for tech companies not to pay any dividends for many years. For example, Microsoft was founded in 1975 but didn’t pay any dividends until 2003. Apple was founded in 1976, and paid its first dividend in 2012.
Another very specialized type of business entity is the professional corporation. For some professionals looking to set up a practice, such as veterinarians, lawyers, accountants, or doctors, this type of business entity may be required by the state in which they practice.
Professional corporations are governed and taxed like conventional corporations, and the only real difference is the restriction that all shareholders have to be licensed professionals.
Note also that some states provide for professional limited liability companies.
Launching your new business is always an exciting time, whether this is your first experience as a business owner or you’re an experienced entrepreneur. But if this decision is not approached carefully, many entrepreneurs may make significant legal mistakes that could impact the business’s future success or sustainability.