OEN NewsChoosing the Right Business Entity: A Practical Guide for Entrepreneurs

Starting a business involves countless decisions. But one early decision can shape your potential tax liability, fundraising options, risk exposure, and long-term flexibility: your choice of business entity. This guide breaks down the major entity types (and the consequences of operating without a legal entity) through the lens of the key considerations founders need to think about.

Sole Proprietorship

A sole proprietorship is not a distinct legal entity; instead, it automatically results from operating a business without forming an entity. All business is conducted in your own name (or a “doing business as” name, if you’ve filed for one) and income and expenses go directly on your personal tax return. A sole proprietorship is fast, easy, and free to start, but comes with many disadvantages, the two most significant of which are:

There is no liability protection, so creditors and plaintiffs are free to go after your personal assets (including those that have nothing to do with the business) to satisfy the business’s obligations.
Serious investors and more sophisticated customers and partners will avoid a sole proprietorship, so it will be difficult to grow your business.

Bottom Line: Sole proprietorships are only suitable, if ever, for low-risk or no-risk hobby businesses or brief forays into testing new business ideas. Most serious entrepreneurs move quickly to forming an LLC or corporation.

General Partnership

Similar to a sole proprietorship, a general partnership automatically results when two or more people agree to operate a business without forming an entity. Co-founders who skip the step of forming an entity before getting too deep into a new venture may discover they’ve unwittingly fallen into a general partnership. The general partnership is, if anything, worse for a business owner than a sole proprietorship. It combines the lack of liability protection and unfriendliness to investment of the sole proprietorship with the complexities of partnership management and taxation rules. General partners have the option of entering into a partnership agreement that can customize certain areas of the partnership’s governance, but your time and money is better spent forming an LLC and working on an operating agreement (see the next section).

Bottom Line: Avoid – not suitable for the vast majority of entrepreneurs.

LLC

For most entrepreneurs not seeking venture capital, the LLC (limited liability company) is the default modern business form (if you are seeking venture capital or angel investment, proceed to the section on corporations). Key advantages include:

Limited Liability: An LLC is a legal entity separate from its owners (“members”), and generally the personal assets of the members are not available to satisfy business debts and lawsuits. When you form an LLC to conduct business, it’s important to conduct business exclusively in the LLC’s name (and not your own), to keep LLC assets and personal assets separate, and to respect the legal formalities of the LLC as an entity separate from yourself. Besides being crucial for a clean legal and accounting record, this helps ensure that the LLC’s separate legal existence will be respected by courts and you will get the benefits of liability protection.
Flexible Structure: An LLC is governed by the rules in the state of formation’s LLC law, but many of those rules can be overridden by the governing agreement between its members (the “operating agreement”). This includes rules regarding management (two common choices are management by the members or management by appointed managers who need not be members), allocation of profits and losses, distributions, admission of new members, and more. Compared to a corporation, where more of the statutory rules are mandatory, an LLC allows business owners to “write their own playbook” and customize the entity to the needs of their business.
Taxation Options: By default, a single-member LLC is disregarded for federal income tax purposes, and a multi-member LLC is treated as a partnership for federal income tax purposes. However, an LLC can change its tax classification to a corporation by making a filing with the IRS.

The main downsides to an LLC are that it’s more difficult to attract investment from angels and venture capital and to issue equity compensation to service providers. If these aspects are part of your business plan, a corporation may be better fit. Also worth noting: unless an LLC elects to be taxed as a corporation, LLC members are generally not going to be taxed as employees even if they provide services as employees, which means (among other things) that 1) the member must pay both the employer and employee portion of FICA taxes, 2) there is no tax withholding and the member must make estimated tax payments, and 3) the member may not be eligible to participate in certain benefits for employees like pre-tax FSA or parking programs.

Bottom Line: The LLC is a good, flexible choice for most entrepreneurs not seeking financing from angels and venture capital.

Corporation

If you plan to raise venture capital, issue options to service providers, and scale aggressively to an exit, the corporation is the standard. Delaware has historically been the state of choice to incorporate in because of the state’s robust body of corporate law and specialized business courts. In recent years other states, such as Nevada, have become increasingly popular, but Delaware is still by far the most popular choice. The corporation shares some characteristics with the LLC – it is a separate legal entity that offers liability protection for its owners – but offers less flexibility, which can lead to increased corporate maintenance costs or a poor fit with the business you are trying to build. The key characteristics of the corporation are:

Legal Structure

A corporation is owned by its shareholders. Formally, the shareholders elect a board of directors to act as the business’ ultimate managerial authority, which in turn appoints officers to administer the business’ day-to-day operations. In practice, an early stage company will likely have the same individuals serving as shareholders, directors, and officers, but it’s important that the procedures and formalities in the corporate law of the state of incorporation are followed to ensure actions taken by the corporation are valid and that liability protection is respected. As with an LLC, it’s important to conduct business exclusively in the corporation’s name (and not your own) and to keep corporate assets and personal assets separate.

Tax Treatment

Subject to corporate income tax.
Distributions (dividends) taxed again at the shareholder level – this is often called the “double taxation” issue.
However, startups often have little taxable income initially.
Major benefit: Potential for Qualified Small Business Stock (QSBS) tax exclusion, which provides shareholders with an exclusion for up to $10M of gain realized on a stock sale of the corporation if requirements are met. The QSBS requirements are complex and easy to run afoul of – consult your legal counsel if you are interested in taking advantage of this tax exclusion to make sure shares of your corporation are eligible and your corporation remains in compliance.

Why Venture and Startup Ecosystems Prefer the Corporation:

Clear, well-litigated corporate law.
Easy to issue multiple stock classes, allowing investors to receive preferred stock with special rights (possible with LLCs, but more complicated).
Easy to set up formal equity compensation (e.g., stock options).
Potential for QSBS treatment.

Bottom Line: Corporations are the best choice for an entrepreneur seeking investment from angels and VCs, looking to issue equity compensation to many service providers, and contemplating aggressive exit scenarios.

Additional Tips and Considerations

You are not required to form your entity in the state where you will primarily conduct business – consider with your legal counsel whether you should choose your home state as your state of formation or another state (such as Delaware for corporations seeking venture capital or angel investment). Each state has its own rules governing the formation and maintenance of entities formed there. If you do choose to incorporate in another state, note that you may need to register your entity as a “foreign” entity in the states where you do business.
Entities are formed by filing a document with the designated government office of the state of formation you have chosen – but the setup doesn’t stop there. To complete the formal organization of your entity, consult with your legal counsel to make sure you have a written operating agreement (for an LLC) or bylaws (for a corporation) in place and that, for a corporation, the initial board of directors has held the organizational meeting required by state law.
Annual maintenance filing and fees are critical parts of keeping your entity in good standing and open for business, but it’s all too easy for busy founders to let these fall through the cracks. Know your deadlines and set electronic reminders on your preferred calendar or task-tracking solution, and watch your email and mailbox for reminders and other key notices from your entity’s state of formation and any other states where it is registered.

ABOUT STOEL RIVES

Stoel Rives is a leading US corporate and litigation law firm providing sophisticated business clients high quality legal services. With offices in seven states and Washington, D.C., Stoel Rives is a nationally recognized leader in project finance and the energy and natural resources industries. From deals and disputes to compliance and counseling, clients turn to Stoel Rives for their most complex business challenges.