There are many factors to evaluate when preparing to launch a startup: from financial issues and business strategies to marketing. One of the main points is the legal registration of the business.
When registering a startup in the United States, you face a choice: which legal structure to choose, how to register it, and how to formalize relations with partners? Let's look at the main types of legal structures for startup registration.
1. Sole proprietorship
A sole proprietorship is the simplest structure for the legal registration of your startup. A sole proprietorship does not require mandatory registration if you work as a self-employed person on your own behalf. If your sole proprietorship business will be operating under a name other than the owner's name (for example, "Joe's Coffee"), most localities will require you to register a DBA (“doing business as”) name.
What do you need to know about Sole proprietorship?
An entrepreneur is responsible for the activities of his startup. All debts that the business has are personal debts of the entrepreneur
A sole proprietorship is easy to establish. You don’t need to take legal steps to form this business type. If you are the only owner and begin conducting business, you become a sole proprietorship. There is no need to formally file paperwork or submit anything at the federal, state, or local level to be recognized as such
Registration is required only in case of using a separate name
An entrepreneur can hire employees and independent contractors. Remember that you will need to obtain an EIN (also known as a Federal Employer Identification Number or FEIN) if you plan to have employees
The entrepreneur is taxed at the federal and state levels. This type of taxation makes it possible to optimize part of the taxes because some states do not charge them at their level. Such states include Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. All of these states, except Alaska, do not have a general requirement for entrepreneurs to obtain licenses
Some states may require a license for a sole proprietorship. Licenses and permits are required for certain business activities, in specific locations, at both state and federal levels
Advantages of a sole proprietorship
Taxes: You don’t need to separate taxes for your business. Any profit you make is simply treated as your own income
Maintenance: A sole proprietorship is more accessible to start and maintain than a registered business. With minimal legal costs and no ongoing state requirements, you can simply run your business. This is the case even if you’re using a fictitious name, also called a DBA (doing business as)
Control: The sole proprietor has complete control and decision-making power over the business. Without any partners, you are the sole owner of the business and can therefore run it as you choose
Minimal paperwork and low set-up costs are two significant benefits of having a sole proprietorship. In addition, there is the ease of maintaining it. A sole proprietorship is the simplest and least expensive business type for establishing for those who do not plan to expand or sell the business in the future.
2. LLC (Limited Liability Company)
LLC (analogous to a limited liability company) is a corporate structure in the United States. LLC can be created individually or together with other persons. The company must be registered under the laws of the relevant state. LLC is the most popular organizational structure in the United States. Among the famous ones are Google and PepsiCo.
What do you need to know about an LLC?
LLC members are not liable for their property for the company's obligations
There are several taxation options. For tax purposes, the IRS (Internal Revenue Service) may treat an LLC as a corporation, partnership, or as part of the LLC owner's individual tax return
LLC members can be individuals and legal entities
Such a company can be registered by a non-resident of the United States
The company's income is not separately taxed
There are restrictions on the type of activity of the company. This organizational form is not suitable for banks and insurance companies
Advantages of an LLC
Flexible membership: Members can be individuals, partnerships, trusts, or corporations, and there is no limit on the number of members
Management structure: Members can manage the LLC or elect a management group to do so
Pass-through taxation: LLCs typically do not pay taxes at the business entity level. Any business income or loss is "passed-through" to owners and reported on their personal income tax returns. Any tax due is paid at the individual level
Heightened credibility: Starting an LLC may help a new business establish credibility more so than if the business is operated as a sole proprietorship
Limited compliance requirements: LLCs face fewer state-imposed compliance requirements and ongoing formalities than sole proprietorships, general partnerships, or corporations
LLC is suitable for startups that aim to limit the liability of members but do not want to register a large corporation and pay taxes at the company level.
Often, when choosing a business structure for future business, people prefer LLC. However, in most cases, entrepreneurs do not consider all the features of this structure. Subsequently, they realized they should have chosen a corporation because they needed to sell their shares publicly or create a board of directors to control the company's activities.
3. S-Corporation
S-Corporation — tax definition for certain corporations and partnerships that have chosen the appropriate type of taxation. The main feature of corporations is the limited liability of their shareholders. Shareholders of an S-Сorporation are not liable to creditors for the company's debts.
What do you need to know about S-Corp?
This type of corporation is only available to US residents
Have only allowable shareholders: may be individuals, certain trusts, and estates and may not be partnerships, corporations, or non-resident alien shareholders
There is no double taxation. It is possible to transfer the profit earned by the company to the personal income of members and not be subject to corporate tax
The activity of such a corporation does not depend on the owner. The exit of the main shareholders does not affect the company's activities. This makes it possible to sell the company by selling shares to other members
Number of shareholders — no more than 100 people
This type of corporation cannot have more than one class of stock
The S-Сorporation can not be a bank, insurance company, Domestic International Sales Corporation (DISC), or a former DISC
Advantages of a S-Corp
Pass-through taxation. S-Сorporations are taxed as partnerships, meaning profits and losses are passed-through to individual shareholders. This can save businesses money on taxes by avoiding federal and state income taxes
Limited liability. S-Сorporation shareholders are protected from personal liability for the debts and obligations of the business. If the business is sued, the shareholder's assets are not at risk
Easy transfer of ownership. In many cases, a shareholder can transfer ownership of an S-Corp simply by selling their shares to another shareholder
Why, among all types of corporations, S-Corporation should be chosen for a startup?
S-Corp is a corporation that combines excellent conditions for a startup. For example, here are the characteristics of other types of corporations:
C-Corp is a legal entity that is separate from its owners and is an independent business entity. Such a corporation provides its members with protection from personal liability. C-Corp is best known for the possibility of double taxation. Such corporations are taxed twice. First, they pay income tax at the company level, and then additionally, when paying dividends to their members. Meanwhile, S-Corp allows its shareholders not to be subject to double taxation
S-Corps are restricted to no more than 100 shareholders, and shareholders must be US citizens/residents. C-Corporations have no restrictions on ownership.
S-Сorporations can have only one class of stock (disregarding voting rights), while C-Сorporations can have multiple classes
B-Corp is a corporation established to achieve a specific purpose recognized by the state as a public benefit. S-Corp, in turn, does not need to declare one purpose and can carry out activities in a wide range of areas.
Close Corp is a closed corporation, which is similar in type to B-Corp, however, has fewer requirements for compliance with formalities. Such corporations are closed to investment by the general public as they are not publicly traded. Unlike an S-Corp, a Close Corp will be subject to double taxation. The shareholders face limited liability for any debt the close corporation may face. Close corporations can opt into S-Corporation tax status since close corporations are business structures regulated by the state and S-Corporations are taxable entities
Non-profit corporation. This type is suitable for charitable, religious organizations, and not-for-profit organizations
Compare the general traits of these business structures, but remember that ownership rules, liability, taxes, and filing requirements for each business structure can vary by state. The following table is intended only as a guideline.
To choose the proper startup business structure, you must decide on the scale of the business and decide whether you will have partners or work alone.
There is no single right option, it all depends on various factors. If you plan to start a startup on your own, are ready to take risks with your property, and do not plan to expand your business significantly — the best choice is individual entrepreneurship. If you plan to significantly expand your startup, involve partners in the activities of your company, and be protected from personal liability by your property, LLC is a good choice. If you are a resident of the USA and do not want to attract more than 100 shareholders or plan to sell your company in the future, then S-Corp will be an appropriate choice.