When you’re forming a new business, choosing the right legal business structure can pave your way towards growth. Although the business structure is typically not as popularly discussed as digital business tools like Slack, Dropbox, or Trello, your starting structure can dictate how you run your company, pay your taxes, and deal with legal matters. All of these are crucial elements if you want to thrive and not just survive in the cutthroat world of tech startups.
Becoming a sole proprietor is the fastest and simplest way to start running a small business. Some states and cities have specific rules governing the formation, management, and taxation of partnerships, corporations, and limited liability companies. This isn’t the case with a sole proprietorship, the rules for which are pretty much the same across the country.
Sole proprietors also don’t need to worry about complicated business taxes. Apart from certain fees in some areas, taxation happens mostly through the sole proprietor’s income tax.
The main caveat to a sole proprietorship is the lack of legal liability protection. Legally, a sole proprietor and their business are considered to be just one entity. While this is what saves lone business owners from having to pay business taxes, this also means that their personal accounts and assets may be seized in the event that they have to pay for any debts or liabilities their business incurs.
This can make startups particularly vulnerable in the notoriously litigious world of emerging tech. In short, being a sole proprietor is fine if you’re a lone business owner who’s just starting out. But the bigger you get, the more you should consider the next options.
Also Read: Big Data Solutions for Small Businesses!
Two or more business owners or founders make up a partnership. There are different types of partnerships that can be formed. However, tax-wise, all of them are typically considered to be ‘pass-through’ entities. This simply means that partners don’t have to pay business taxes and instead pay through their individual income tax – just like sole proprietors. At the same time, unlike a sole proprietorship, a partnership offers a limited amount of legal liability protection.
In general partnerships, for instance, legal liability, operational responsibilities, and income and losses are all equally shared among partners. Meanwhile, in what’s known as limited partnerships, those who are limited partners are legally considered only as investors – sharing neither responsibility nor legal liability with other partners. And last but not the least, you can also form a limited liability partnership (LLP), a special structure that enjoys certain tax breaks and other benefits – but is subject to stricter formation rules.
For instance, in the Franchise Tax Board’s overview of the requirements for starting an LLP in California, it’s clearly indicated that only lawyers, architects, and accountants can form an LLP.
In California, LLPs don’t pay income taxes and are instead subject to an annual $800 tax. An LLP is an ideal structure for tech startups whose founders are licensed practitioners in the aforementioned professions, such as those developing job-specific apps or other technologies.
Apple, Microsoft, and Google are just some of the biggest and most well-known tech corporations on the planet. This underscores why companies go corporate – to go big. Incorporating means that shareholders and their businesses are considered legally separate entities, which means full legal liability protection for shareholders.
This is typically the main reason why companies incorporate, as this protection paves the way for growth with fewer legal risks. Furthermore, incorporation sets the stage for going public, allowing shareholders to sell percentage shares of the company to rake in big investments. Because of all this, corporations are also required to form a board of directors for voting on matters pertaining to the operations and ownership of the company.
Just like partnerships, there are different types of corporations you can form. Arguably, the main disadvantage of any corporate structure is ‘double-taxation’ – once through federal business taxes and again through shareholder’s individual incomes.
Every business that incorporates is automatically designated as a C corporation, gaining all the aforementioned corporate benefits, but with the caveat of being taxed twice. You can avoid double taxation by trying to register as an S corporation, but only if you’re a legal and permanent U.S. citizen, have no plans of going beyond 100 shareholders, and require only limited legal liability protection.
Meanwhile, the B corporation designation is reserved for businesses that meet the highest corporate standards for socially and environmentally-forward practices.
Although successfully registering as a B corporation is no easy task, it comes with lots of benefits. This includes federal green tax credits as well as gaining the interest of investors in private foundations, many of which are desperate to do business with progressive companies.
Furthermore, some areas may afford confirmed B corporations certain additional benefits, such as the Sustainable Business Tax Credit in the city of Philadelphia in Pennsylvania. Whether or not you’re planning to do business in Philly, forming a B corporation could be the ideal move if your business idea heavily involves social and/or environmental initiatives.
Limited Liability Company
Creating an LLC is arguably the best choice for startups working with tech and/or business ideas that are difficult to categorize within any of the other aforementioned structures. The reason for this is that LLCs afford members the limited liability protection of corporations, as well as the option to be considered as ‘pass-through’ tax entities just like partnerships or sole proprietors. In addition, although LLC formation rules tend to differ from state-to-state, it’s typically cheaper and much more flexible than incorporation.
For instance, drafting an operating agreement to form an LLC is not a legal requirement here in the Lone Star State. At the same time, ZenBusiness’ steps to starting an LLC in Texas documents how founders can use this agreement to determine their company’s ownership percentages, management structure, protocols for bringing in new members, and even the specific powers and privileges of each member. LLCs through the certificate of formation may also decide how they will be taxed, including being fully exempt from taxes as a nonprofit company.
In short, LLCs are like much more flexible corporate entities. And this has made LLC formation popular for many startups, whether or not they’re involved in new tech. But while forming an LLC is the ideal choice for many, this doesn’t necessarily mean that it’s the best structure for you.
In fact, whether you want to form a sole proprietorship, a general partnership, an LLP, an S corporation, a B corporation, or an LLC, you should first consult your business lawyer and accountant before signing and paying for any of the required paperwork.
While you can always decide to change your legal business structure, such a decision requires money and time – costs that you can avoid paying if you instead start with the structure that lines up with your immediate and long-term goals.