Which type of business to form?


3

I'm currently starting up a small business with two other partners who are very trustful friends. The business is mostly software, along with one small piece of hardware. We've talked about the formalities of business ownership but haven't incorporated or in any other way become official.

I've dished out a few thousand dollars this year that I'd really like to claim as expenses towards the business for tax purposes (at least, I assume we can write off these expenses). So, I'm itching to get the business officially formed.

One big issue is that we don't know exactly which structure to pick. Incorporating sounds great, but it also sounds sort of overwhelming, confusing and time consuming.

What structure would people suggest which:

  • protects us all (meaning, we all get a certain percentage ownership in the company)
  • protects us personally (we can't personally be sued)
  • is fairly easy to do (can we do it without a lawyer?)
  • is fairly inexpensive (we have yet to generate any revenue)

I know there is not always a right answer to this question, but I'd love to hear suggestions. We're in California.

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asked Nov 17 '09 at 12:58
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Brianz
223 points
  • Which country? Laws differ from country to country... – Jesper Mortensen 9 years ago
  • We're in the U.S...California specifically. Question updated. – Brianz 9 years ago
  • Thanks to everyone for the great feedback...this is fantastic! I wish I could "accept" all of the answers, because they all helped. – Brianz 9 years ago

5 Answers


3

To your point, this is kind of an involved question. The various trade-offs get into what kinds of liability protection is extended to owners, what types of corporate structures are dictated by the state the company is formed in, how income is distributed and treated from a point of taxation, etc.

First, to get one thing out the way, nothing prevents you as an owner or stockholder of the company from getting sued no matter what type of legal structure you put around the company. That is, you can't prevent anybody from suing you, because anybody can choose to sue whom ever they want and it is not uncommon for such persons to sue both the company and owners of the company individually. With that said, the primary protections you are probably looking for here are relative to debt obligations of the company being insulated from personal holdings. Getting such protections and having multiple owners rules out the simple structures of sole proprietorship, and general partnerships. Therefore, this puts you into one of the follow types of structures:

The LLP type, gets you the main liability protections of a corporate entity type structure, but still distributes income like an ordinary partnership and also gets similar tax treatment. That is, partnership income is divided up amongst the partners based on ownership percentages and taxed directly as personal income. Law firms and medical practices commonly use the LLP structure.

The LLC or Corporation structures are used for most other business types. These structures create a completely separate entity of liability, income generation, and taxation. These structures also introduce the notion of retained earnings held within the company and the ability to carry forward losses into future tax years, etc.

The standard "Corporation" is a more rigid structure in each state and there are specific rules and guidelines to how the company is formed, what type of "roles" must be defined (like treasurer, secretary, etc.). The LLC is a similar kind of thing, but the charters of the company can customize almost all aspects of formation and exactly how the company is setup. Think of the LLC is a much more flexible version of a corporation.

It's pretty common that new product or software companies are now formed as LLC unless somebody is really hung up on having a "Inc" at the end of the name. I am not aware of any specific advantage of a traditional corporation except that perhaps more people are familiar with them. Certainly, the newer LLC form is much more flexible and customizable in how it is defined.

Finally, while your desire to save money and avoid a lawyer is somewhat admirable, this is not a place that I would recommend to do that. Discussing the specifics with your exact situation with a lawyer and getting a recommendation is not really going to cost you all that much money and you really do want to get this right. My suggestion is to first read up on this topic as much as you can, going to the lawyer as informed as possible, tell them what you think you want them to do, have them advise on your selections, adjust as necessary, and then have the lawyer do the filings.

Note: Assuming that you are going to end up with an LLC or tradition Corporation, the other thing you are going to want to have drafted up is some sort of stockholder agreement that puts some of vesting schedule on the "founders" shares. See this for why.

answered Nov 17 '09 at 13:56
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Tall Jeff
1,406 points
  • Good answer. I assume this answer is intended for readers in the USA? – Jesper Mortensen 9 years ago
  • Yes - especially California (other states may or may not offfer LLCs) – Bob Walsh 9 years ago
  • Yes, good point. Some of the specifics are USA centric and also, not all states offer the LLC option. Although, to be clear, you can incorporate in another state if you so choose. For example, Delaware is a very common state to incorporate in due to many business friendly and flexible corporate provisions. (See http://bit.ly/2nBwxz ) – Tall Jeff 9 years ago

1

The most common solutions are to form a C Corp, S Corp, or LLC. All of them protect your personal assets (i.e., confer limited liability) and can be done without a lawyer. The expense depends on a number of factors, including

1) filing fees for the state in which you incorporate
2) service provider fees if you use a third-party incorporation service.

Both Corps and LLCs allow you to structure ownership percentage to your specifications. There are pros and cons to each, which depend largely on your specific case (e.g., whether you intend to seek VC investment, grant employment equity, etc).

I'd be glad to give you more info based on your specific case. Feel free to DM me @joshfeola

answered Nov 17 '09 at 13:57
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Josh Feola
71 points

1

Obviously, this is advice that should not be acted upon without legal council. However, based on your current description, I think your most viable options would be either an LLC or an S Corporation. Here is a link describing the two in detail: LLC vs. S Corp Both companies are taxed as a pass-through entity, e.g. via your personal income tax. However, an LLC is typically easier to set up and run (easier equity arrangements, no mandatory meetings or keeping track of minutes etc..).

The main differences are:

  • the LLC is not a separate entity- its life ends when a partner passes away or undergoes bankruptcy. (Although this can be bypassed in the bylaws)
  • it is more difficult to take an LLC public than a transition from S corp to C corp
  • the S Corp may have easier access to credit for loans etc...
  • conflicts/disagreements between shareholders in an S corp can immobilize decision making.

I'd suggest an LLC, unless your planning to go public within a couple years. Here is another link which compares all U.S. business types: Business Entity Comparison Chart Hope this helps!

answered Nov 18 '09 at 02:37
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Nbeecroft
515 points

1

Either an LLC or S Corp will work, with the LLC having less paperwork, and the S Corp a lower likihood of being audited by the IRS. In either case the FTB will collect $800 a year regardless. A couple of points to think about:

  1. Some form of pre incorporation partner agreement is a must. There's a Guide at StartupToDo.com written by the CEO of FairSoftware.net on how to do this: basically FairSoftware has done the heavy legal lifting re a partnership agreement and you can use that, free, then set up either the LLC or S Corp.
  2. The three big issues that need to be tackled in that agreement is what if a partner wants out or to sell their share, what if they die (does their family become your new partners) and what if they don't perform. Stressful issues to discuss with friends, but necessary.
answered Nov 18 '09 at 03:38
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Bob Walsh
2,620 points

1

I'll give you straightforward advice: Go to a lawyer for this.

The best thing you can possibly do is to do this in conjunction with a lawyer and an accountant.

A lawyer will ask you questions such as "I know you are all buddy-buddy right now, bu what happens if you get angry at each other and one of you wants out? What happens with the company's debts?". If you think talking about it is hard right now, imagine how hard it's going to be to settle it once you are in debt, someone's feeling angry, and the friendship is on the line? A lawyer can "force" you to think about such things in advance. Later on IF there is a problem, you will have previously agreed in writing on how to solve it. The lawyer will put this wording into the paperwork. What if one of you passes away or is unable to continue through no fault o his own? Will the partner's spouse get a formal say in how the company is run? The possible scenarios go on and on... Things that can be major problems later should they occur.

An accountant is needed because you will present your ideas about revenue (when will it come, how much, how do you expect to receive it, when you will use it, etc...) and then the accountant will recommend an appropriate structure for it.

Believe me, it will be the best money you ever spent. Even if you think you cannot afford it right now.

answered Nov 18 '09 at 03:59
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Gabriel Magana
3,103 points

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