One recurring question early-stage entrepreneurs often ask is: What business entity structure is best for my startup? Like most legal issues, it depends on numerous factors, such as the nature of your business, the number of founders, your goals, etc. There is no single best business entity choice for all startups or even all startups engaged in the same industry. Despite what many legal form websites suggest.
To help guide you in choosing the best entity structure for your startup, here are most common types of business entity structures.
Business Entities
1. Sole Proprietorship
A Sole Proprietorship is the default business structure. Nevada defines a Sole Proprietorship as: “any natural person who owns and operates a business where there is no legal distinction between the owner and the business. The owner receives all profits and has unlimited responsibility for all losses and debts.”
Essentially, there is no legal distinction between a Sole Proprietorship and the individual owner of the business. Therefore, the owner is personally liable for the business’s obligations and the business cannot live on past the death of the owner. For tax purposes, all profits and losses flow through directly to the owner.
The only notable advantage of a Sole Proprietorship is its simplicity. Conversely, there are significant disadvantages that come with co-mingling personal and professional liability.
As stated above, Sole Proprietors are legally responsible for all liabilities the business incurs. Therefore, short of bankruptcy, these liabilities could follow you for life.
Often, Sole Proprietors choose to file a DBA which is an acronym for “doing business as.” This is necessary when your business operated under a trade name. This does not serve any structural purpose. It is simply an alias that puts a professional facade on your Sole Proprietorship and is done for marketing purposes. Consequently, it does nothing to shield the owner of the Sole Proprietor from personal liability.
2. Partnership
If you need help running your startup, you might consider a Partnership. Partnerships operate similar to sole proprietorships. Thus, there is little formality required to form a Partnership and no legal distinction between the Partnership and the individual owners.
The owners usually enter into some sort of formal partnership agreement. However, it may not require a filing in most states. Nevada defines a General Partnership as: “An unincorporated company formed by two or more persons. Owners are personally liable for any legal actions and debts the company may face.”
Partnerships are simple to start and operate. Moreover, a partnership provides the added benefit of allowing the partners to raise money by selling partnership interests.
In Nevada, you will be personally liable for the General Partnership. In other states, there may still be a fuzzy line between personal and business finances. Consequently, it is not wise to ever assume limited liability within a Partnership. There could also be some potential confusion around partner roles, responsibilities, and liabilities depending on the depth of the Partnership Agreement.
3. Limited partnership
A Limited Partnership (“LP”) is a variation of a partnership. As the name suggests, the limited partners have limited liability. The LP’s general partners have the same personal liability as a partner is a Partnership.
In the case of an LP, the general partners are responsible for managing the day-to-day business. The limited partners act as investors who can only purchase limited partnership interests. If limited partners act as general partners, the IRS and courts will treat them as such for liability purposes. Therefore, it sometimes helps to think of limited partners as truly “silent partners.”
This structure is popular in certain industries such as finance (Hedge Funds, VC Funds, etc.), film, real estate development, and oil and gas exploration. This is because LPs can be used for the limited duration of the project and end with a final distribution.
On one hand, having a Limited Partnership legally requires limited partners to keep their hands off the day-to-day operations. However, entrepreneurs might not be fans of this structure because there’s no built-in protection for them.
4. Limited Liability Company (LLC)
A Limited Liability Company (LLC) provides a hybrid legal structure. First, it offers pass-through taxation like a partnership. Second, it provides members with the limited liability of shareholders of a corporation by formally segregating personal assets from company assets. An LLC is formed by filing articles of organization with the State. LLCs do not have to have boards, hold annual meetings, or record minutes like Corporations.
In an LLC, there is no limit to the number of members. Additionally, ownership can be broken down into different classes. This gives entrepreneurs significant flexibility when it comes to raising equity financing and retaining control of voting rights. This structure can make sense if your company is at the stage where it might attract friends and family or angel investors. For various technical reasons, it is often the case that professional investors prefer purchasing stock in a corporation over purchasing membership interests.
5. C Corporation
A Corporation is a legal entity that is distinct from its owners. It can only be created by filing specific documents with the state. The owners of the corporation are shareholders and are generally not personally liable for the obligations of the corporation.
The board of directors often manages the company. The board delegates the day-to-day management obligations further. Ownership interests are freely transferable and the corporation has perpetual existence. C Corps have double taxation. C Corps are taxed at the corporate level and shareholders also subsequently pay taxes on dividends. However, this is not an issue for many early-stage startups that are more focused on growth.
If you are an early-stage startup that has its sights set on venture capital, opting for a C corp often makes sense because this is the preferred entity choice of professional investors.
6. S Corporation
Tax laws allow certain Corporations to make an election with the IRS to be taxed as partnerships. S Corps are pass-through entities that take advantage of Subchapter S of the Internal Revenue Code. This allows S Corps. to avoid taxation of corporate income. Therefore, the profits and losses flow through to the owners like a partnership.
S Corps have a number of relevant restrictions. (1) There can only be one class of stock. (2) There cannot be more than 100 shareholders. (3) Each of the shareholders must be an individual.
An S Corp is a good option for you if you want to limit the number of shareholders and need liability protection. S corps are not ideal if your goal is to seek venture capital because you’re limited to one class of stock, which eliminates your ability to do multiple financings.
Changes in corporate structure are often permissible. However, it is often advisable to initially seek professional help when figuring out which business entity structure suits your business goals. This is especially true if your business is looking to raise capital now or in the future.
Chasen Cohan, Esq. is the founder of Cohan PLLC. Mr. Cohan is a licensed attorney who also possesses FINRA Series 7 (Registered Representative) and Series 63 (Uniform State Representative) licenses, state insurance licenses, and State Securities Registrations in Nevada, Missouri, and North Carolina. Mr. Cohan is admitted to practice law before the Nevada Bar, all Nevada State and Federal Courts, and the United States Court of Appeals for the Ninth Circuit.
Mr. Cohan’s representative clients have included: Wal-Mart Stores, Inc., Sam’s West, Inc., MGM Grand Resorts International, New York-New York Hotel & Casino, Mandalay Corp., The Treasure Island Hotel and Casino, The Cosmopolitan of Las Vegas, The Mirage Casino-Hotel, South Point Hotel & Casino, American Express, Barclays, US Bank, Wells Fargo, Citibank, and various life insurance companies and service providers.
Mr. Cohan is a Las Vegas native who graduated with honors from UCLA with a Bachelor of Arts degree in Political Science. Mr. Cohan received his Juris Doctorate from the University of Texas School of Law. During law school, Mr. Cohan served as a clerk for the Office of the Texas Attorney General and a Judicial Extern for United States District Court Judge James R. Nowlin.
Clients from global brands and middle-market companies to innovative startups and individuals trust Cohan PLLC to resolve their trickiest legal disputes. Whether that’s litigation in state or federal trial and appellate courts in Nevada; investigations and enforcement actions before government agencies; or mediation, arbitration, and regulatory agency proceedings. Cohan PLLC has litigated hundreds of millions in dollars of claims on behalf of corporate litigants. As a result of this experience, Cohan PLLC has been afforded the opportunity to selectively act as Plaintiff’s counsel on complex, personal injury matters.