Choosing the Right Business Structure
One of the first decisions an entrepreneur makes is choosing the optimal business structure for the new business. This choice shapes liability, taxes, governance, fundraising potential, and long-term scalability. The decision isn’t just about how the business operates now, but also about how it can grow in the future.
While some businesses choose to operate informally without incorporating, most need to balance these considerations when determining the optimal structure. Attorneys, accountants, and other business advisors play an instrumental role in this decision.
C Corporation (C Corp)
Companies seeking to raise capital from venture capitalists and other institutional investors often choose a C Corporation. Investment funds, including venture capital funds, are usually restricted from investing in pass-through entities because these entities can generate taxable income that may not be optimal for the funds’ investors.
Only C Corporations can issue preferred stock—the type venture capitalists typically take. In addition, investment funds generally can’t hold shares in S Corporations.
Although C Corporations generate double taxation—once at the company level and again at the shareholder level when distributing profits—they offer investors a powerful tax break: Qualified Small Business Stock (QSBS), also known as the Section 1202 exemption.
If investors hold the stock for five years and the company meets certain qualifications, they can exclude up to $10 million or ten times their investment from long-term federal capital gains taxes.
Limited Liability Company (LLC)
Small businesses that are not seeking institutional investment capital, and are often funded by the founders themselves, are often good candidates for a Limited Liability Company (LLC). An LLC is one of the most popular business structures for these types of businesses. This is because it offers legal protection while maintaining operational flexibility.
LLCs provide liability protection by shielding the personal assets of the owners. At the same time, LLCs benefit from pass-through taxation. This means profits go directly to owners without being taxed at the corporate level, in contrast to a C Corporation. However, self-employment taxes still apply.
The owners of an LLC are referred to as “members” rather than “shareholders.” Business owners can operate a single-member or multi-member LLC. They can also choose to have it managed by the members or by a manager who may, but does not have to, be a member.
S Corporation (S Corp)
An S Corporation (S Corp) is also a structure that works for small businesses not seeking institutional capital. As noted above, institutional investors may be precluded from investing in an S Corporation. Since S Corporations can issue only one class of stock, they could not issue preferred shares to investors.
Profits and losses pass directly to shareholders. This means they are only taxed at the individual level.
S Corps, however, must follow strict IRS rules. These include a limit of 100 shareholders. All of them must be U.S. citizens or residents.
Partnerships (LP & LLP)
Partnerships, including Limited Partnerships (LP) and Limited Liability Partnerships (LLP), are typically used for certain types of businesses. These include investment funds and real estate investments. Partnerships are less likely to be a consideration for most startup businesses outside of these areas.
In an LP, the general partner (GP) assumes personal liability for the business debts. The limited partners have limited liability but also reduced control. Partnerships benefit from pass-through taxation.
Sole Proprietorship
A Sole Proprietorship is the simplest business structure. It is automatically applied when an individual starts a business without registering another entity type.
It offers complete control to the owner and requires no formal registration. However, the business and the owner are legally the same. This means personal assets are at risk if the business incurs debts or legal issues.
While this structure benefits from minimal legal complexities, the lack of liability protection for the owner’s personal assets should be carefully considered.
Final Thoughts on Choosing the right Business Structure
Choosing the best structure means balancing competing priorities—for example, the double taxation of a C Corporation versus its ability to attract institutional capital.
Consult with attorneys, accountants, and other business advisors to make an informed decision.
Also, remember that any activities before incorporation—such as signing a contract—expose the owner to personal liability. Once you incorporate, make sure to transfer those liabilities to the company and release yourself from personal risk.
Stay tuned for Part 2 of our startup series. We’ll explore why a Co-Founder Agreement matters and how to create one effectively.
