Tips for Founders - Which business entity to choose?

Tips for Founders- Which business entity to choose?

As a founder and entrepreneur, one of the important initial decisions you will make is choosing the right type of business entity for your venture. Two of the most popular business filings are LLC and S Corp, and deciding which one to choose can be a bit confusing, to say the least. Often everyone is giving you a different opinion and they all sound valid, so in this article, we will discuss the differences between these different types of business entities and help you decide which one is the best fit for your business. At the end of the article, we will give you some examples of the style of businesses currently using each entity status, to give you live examples to assist your decision-making.

We will be covering the following:

• What is an LLC and how does it work?
• What is an S Corp and how does it work?
• How to choose between an LLC and an S Corp?
• Other types of business entities to consider
• Examples of businesses and their entities

What is an LLC and how does it work?

An LLC, or limited liability company, is a type of business entity that combines the liability protection of a corporation with the flexibility of a partnership. Here are some pros and cons of forming an LLC:

Pros:

• Limited liability protection for the owners, meaning that their personal assets are protected from the company's debts and legal liabilities.
• Pass-through taxation, where the business itself is not taxed but the profits are distributed among the owners and taxed at their individual rates.
• Flexibility in management and ownership structure.
• No ownership restrictions, allowing both U.S. citizens and non-citizens to own and manage an LLC.

Cons:

• Some states require annual fees and/or additional filings.
• Some investors prefer corporations, as they are more familiar with the structure and governance of those entities.

Example: LegalZoom is a well-known LLC that offers legal services to individuals and businesses.

What is an S Corp and how does it work?

An S Corp, or S corporation, is a type of corporation that allows the business to avoid paying federal income tax at the corporate level. Here are some pros and cons of forming an S Corp:

Pros:

• Limited liability protection for the owners, meaning that their personal assets are protected from the company's debts and legal liabilities.
• Pass-through taxation, where the business itself is not taxed but the profits are distributed among the owners and taxed at their individual rates.
• The ability to avoid double taxation that is common with traditional C corporations.
• Eligibility for certain tax deductions and credits that are not available to LLCs.

Cons:

• More strict ownership requirements, including the limitation on the number of shareholders (up to 100) and the restriction on having non-U.S. citizens as shareholders.
• Higher administrative and legal costs, including the requirement to file annual reports with the state and maintain certain records.
• Limited flexibility in management and ownership structure.

Example: Ben & Jerry's is an S Corp that produces and sells ice cream products.

How to choose between an LLC and an S Corp?

Choosing between an LLC and an S Corp depends on various factors, including your business goals, ownership structure, and taxation needs. Here are some tips to help you make the right decision:

• Consider your future growth plans and whether you may want to attract outside investors or go public.
• Evaluate the ownership structure of your business and whether you plan to have multiple owners or investors.
• Look at the tax implications and decide which entity offers the best tax benefits for your business.
• Consider the administrative and legal requirements of each entity and whether you are willing to take on those responsibilities.

Other types of business entities to consider

LLCs and S Corps are not the only options for business filings. Here are a few other types of business entities that you may want to consider:

• C Corporation: This is a traditional corporation that is taxed separately from its owners and offers limited liability protection. However, it is subject to double taxation.
• Sole Proprietorship: This is the simplest form of business entity, where the business is not separate from the owner and is taxed at the individual's rate. However, it offers no liability protection and may limit the ability to raise capital.
• Partnership: This is a business entity where two or more individuals share ownership and profits. It can be formed as a general partnership or a limited partnership, and it offers flexibility in terms of management and ownership. However, each partner is personally liable for the partnership's debts and actions.
• Limited Liability Partnership (LLP): This is similar to a general partnership, but it offers limited liability protection to each partner. However, the business is still subject to partnership taxation.
• B Corporation: This is a type of corporation that aims to balance profit and purpose, focusing on creating a positive social or environmental impact in addition to generating profits. It must meet certain social and environmental performance standards.
• Limited Liability Limited Partnership (LLLP): This is a hybrid between an LLP and a limited partnership, offering limited liability protection to general partners and allowing them to actively manage the business. However, it may be subject to more complex tax regulations.

When choosing a business entity, it is important to consider factors such as taxation, liability protection, management and ownership flexibility, and the ability to raise capital. It is recommended to consult with a legal and financial professional to determine the best entity for your specific business needs.

Examples of businesses and their entities

Some examples of existing businesses using these types of entities to give you a feel for the style of business are:

• C Corporation: Coca-Cola, Disney, Ford
• Sole Proprietorship: Freelance writers, consultants, and other independent contractors
• Partnership: Law firms, accounting firms, and other professional services firms
• LLP: Law firms, accounting firms, and other professional services firms
• B Corporation: Patagonia, Ben & Jerry's, Warby Parker
• LLLP: Real estate investment firms, private equity firms

This article is part of a newsletter series - Tips for Founders

This series will include general hints and tips for founders going through the grind of starting their businesses, including ideation all the way through to product market fit, scaling, and capital.

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