One of the questions I get asked most often by clients is “What form I should choose to start my new business?” Like many questions a lawyer gets asked, the answer is “it depends.”
The questions I ask a client to figure out the “it depends” are generally centered around the following 4 criteria:
- Appetite for personal liability
- Desire for pass-through taxation
- Concerns for cost and complexity
- Desire to raise outside capital
1. Liability. As to liability, I counsel my clients to avoid sole proprietorships and partnerships as these entity forms do not protect individuals from liability. If they are just starting out and have no assets to speak of, these structures may be an option, but the window for when they make sense is limited and closes quickly as the company is successful, so my advice is to avoid these forms altogether. Also, there are limited liability partnerships for some professions, but again these are not preferred forms, for although one partner may not be liable for the other partners, they are still personally liable for their own actions. Go with LLC’s and Corporations whenever possible.
2. Taxation. The basic rule of thumb is that most people would prefer pass though taxation. Even if an entity is taxed at a lower corporate rate, getting taxed once is generally preferable to getting taxed twice. Tax is not double-mint gum with double the fun! Many of the entities we use for liability reasons can also offer pass through taxation, namely the LLC and the “S” corp. If you want more detail, the National Association of Tax Professionals has a great chart here: https://www.natptax.com/TaxKnowledgeCenter/FederalTaxInformation/Documents/Chart%20of%20Entity%20Comparison.pdf
3. Cost and complexity. For many folks just starting out, having a huge legal bill at the beginning is not a great way to get a company off on the right foot, however, the old adage of being penny-wise and pound foolish certainly applies here. Many of my customers have used services like Legal Zoom, Clerky or Cooley Go to set up their companies, and inevitably find their way to me to clean up the mess they have made. It isn’t that any of these services are bad per se, it is just that there are so many nuances around setting up an entity that you really don’t want to get it wrong. As a general rule, the cheapest entity to set up and manage is the sole proprietorship because it is the least complex, it generally just requires a DBA in the county where the business is located. An LLC is the next lowest in terms of cost and complexity, then partnerships and lastly corporations. The more complex the structure the more expensive it is to set up and to maintain with periodic filings and shareholder/board meetings. Another factor to be considered is in what state you are setting up the company and where you do business, if you are in multiple states you will need to register in each state where you have certain minimum contacts.
4. Desire to raise outside capital. Although this is the most complex area when it comes to creating the appropriate documentation, the determination is easy when it comes to deciding what entity to choose when attracting outside investors. If you intend to bring in money from venture capitalists and private equity there is only one reasonable choice, that is to create a Delaware corporation. That is what is expected because then the investors know the rules of the road and feel their investments are protected. You can try for a California corporation or to sell a membership interest in an LLC, but the expectations of a sophisticated investor will likely become a problem. The LLC and a closely held “S” Corp are great when you have a small group of investors, but can only scale so far, and will never be able to help your startup become the next Silicon Valley Unicorn or billion-dollar company.
Although the above criteria are starting points for a conversation, there are many nuances that can only be picked up in a conversation between a client and an experienced attorney. Such counsel will use years of experience to understand your potential needs and concerns, even if you haven’t yet identified them all. I highly recommend you have that conversation before you get too far down the road of setting up your business.
Business Law Review 