How Should I Set Up My Company?

A frequently asked question I get from entrepreneurs is how should they set up their company. Legally, there are several different ways of setting up a company, each with their own advantages and disadvantages. Here’s a general overview of how they break down in the United States:

Under a sole proprietorship, the business is not treated as a separate legal entity. Instead, it is treated as an extension of the owner.

The benefit of this structure is that it is very simple and works well for businesses that are owned by a single person. From a tax perspective, any of the income (or loss) in the company is treated as income of the owner. This can work well if you don’t need other investors and you expect your business to incur losses early in its life, since these can be used to offset any income in your personal taxes.

The disadvantages of a sole proprietorship are that it it doesn’t work when you need to bring in other investors that will also have to own a portion of the equity of the business, and any liabilities incurred by the business, including loans and bills, are also directly attributable to the sole proprietor, and not to a separate legal entity.

A partnership is a legal entity structure where two or more parties come together as partners, with a partnership agreement defining how much each partner has invested and what the obligations of each partner is.

Partnership agreements can be structured to define different amounts for how much each person invests versus how much of the income they are allocated. Typically, the equity and income allocations will be the same, but specifying different allocations is useful if one of the partners or co-founders cannot contribute a lot of cash, but instead contributes other in-kind equity, such as effort or intellectual property. Partnerships are similar to sole proprietorships from a tax perspective in that any income or loss flows “through” the partnership back to the individual partners and is taxed as if it were that partners’ own income.

Some disadvantages of a partnership are that whenever a new partner invests, the partnership agreement must be revised, and the partners generally all have joint and several and unlimited liability for whatever happens within the partnership. For example, if a partner ship takes out a $1 million loan and the partnership fails, the lender could seek repayment from all of the partners. Limited liability partnerships, or LLPs, attempt to overcome some of these disadvantages of a pure partnership by restricting how much other partners are responsible for the actions of a single partner, but this only applies to certain actions.

A C corporation is the typical legal structure for most large businesses. A C corporation is a distinct legal entity and pays taxes on its own income, unlike a sole proprietorship or partnership where the income flows through to the owners. A C corporation also allows multiple investors, and each investor owns shares in the company. You can also structure different classes of shares for different investors that have varying levels of rights. This is typically seen in venture capital-funded startups, when you hear about a company that received a Series A round of funding, followed by a Series B, and then a Series C and so on. Most importantly, because the C corporation is its own legal entity, the individual shareholders and owners of the company are personally protected from liability.

However, since a C corporation is taxed as its own legal entity, earnings and losses are retained in the corporation and do not automatically flow to the owners. If a C corporation is profitable, earnings can be distributed to the owners and shareholders via a dividend, but for startups the successful exit strategy is typically to either sell the company or to have the company go through an initial public offering, or IPO, where the company’s shares can then be sold on the public market.

Note that since a C corporation is a distinct legal entity, founders are treated as employees of the company and can draw a salary from the company rather than having earnings flow through to them. C corporations also offer more flexibility for structuring equity compensation via stock option incentive plans.

The S corporation is a hybrid of a partnership and a C corporation. It is taxed like a partnership, but retains all the legal protections of a C corporation. There are some important limitations though: S corporations are limited to no more than 75 investors, are only allowed to have one class of stock (although different voting rights among shareholders are allowed), must be a domestic U.S. corporation, all of its shareholders must be U.S. citizens, and at least 20% of its revenues must come from U.S. sources. The stockholders are also largely restricted to individuals, and cannot consist of other corporations or partnerships, which largely prevents venture capital firms from investing in S corporations.

LLCs are unique in that they are distinct legal entities that you can elect to be treated for tax purposes as either a partnership or a corporation. If treated as a partnership, a partnership agreement specifies the allocation of equity and earnings. LLCs are not bound by the same constraints as an S Corporation, and they can be converted to a C Corporation at a later time.

So which legal entity structure is right for a startup? There are two main considerations: How many investors or owners there will be, and how much funding is required. In all cases, if other investors or co-founders are required, you can rule out a sole proprietorship. If you anticipate the business can run for some time with only a small group of founders or investors without requiring additional external funding, then a sole proprietorship, partnership, S corporation, or LLC taxed as a partnership can make sense since it will allow earnings and losses to flow through directly to the partners. However, if additional funding from an outside party like a venture capital firm or passive investor is required, then a C corporation makes more sense since it will be easier to accommodate additional investors.

The right legal entity structure is not a permanent decision – a company can start off as a partnership or LLC, and then convert to a C corporation later in its life when it makes sense for it to do so, but doing so can cost both time and money. Understanding the company’s needs and expected development in its early years can provide clues as to which legal structure is best at the outset. Another major point to consider is what impact the legal entity structure can have on the founders’ and investors’ tax situations in the early life of the startup. For this reason, it’s a good idea to consult with an accountant or tax professional to understand the tax implications.