One of the first steps attorneys often take when helping founders and early-stage startups to start their businesses (or expand them) in the United States is forming a US-based entity. Let’s explore some of the basic business entities that a startup might choose to create.

Sole Proprietorship.

This business entity does not require the founder to do anything. The founder's actions constitute proof that he/she started a business. Actions like hiring employees, creating prototypes, selling products basically determine that the founder created something called a sole proprietorship.

The benefits of creating a sole proprietorship are: (a) the simplicity to create the business; and (b) there is no additional layer of tax (no taxation both at the corporate level and at the individual level).

The disadvantages are quite significant: (a) no limited liability, so if there's a problem and the entity is sued, individuals will have access not just to the money in the founder's business but also the founder's personal wealth; maybe if he/she owns a home or family assets, those could all be subject to litigation, (b) it is also really difficult if the founder wants to issue equity to employees or to investors, it is almost impossible to do that as a sole proprietorship, (c) it is very difficult for the founder to have a strategy around intellectual property, and then, (d) if the founder wants to scale his/her business with venture capital, most venture capitalists will almost always avoid investing in a sole proprietorship.

Partnerships and Limited Partnerships.

A general partnership is any association of two or more people who carry on a business for profit.

No state filing is needed to create a common-law partnership, and all partners are jointly and individually liable for the debts and obligations of the partnership.

A limited partnership is generally advisable over a general partnership, as it offers limited liability protection to its limited partners, although formation requires a state filing. Limited partnerships must have at least one general partner with unlimited liability, but the general partner is frequently considered a separate limited liability entity. There may be any number of limited partners, and their liability is limited to their investment in the partnership. Limited partners, however, must not take any part in the management of the business, or this liability protection may be forfeited.

Unlike corporations, partnerships are not taxed at the entity level. All the partners report their respective share of income on their own tax returns, thereby avoiding the double-taxation problem of a C corporation.

Limited Liability Companies (LLCs).

An LLC (or Limited Liability Company) is an entity type that can be operated either by its members or by managers elected by the members. Managers are similar to the directors of a corporation. Many LLCs are managed directly by their managers, but sometimes managers will elect officers to conduct the LLC’s day-to-day business activities.

The members (meaning the “owners”) of an LLC enter into an operating (or similarly titled) agreement to govern the operations of the company in a manner similar to corporate bylaws. An operating agreement may include restrictions on the transfer of membership interests (“equity”) and may create multiple classes of membership interests, each with their own preferences and voting rights.

Just like a corporation, the founder of an LLC gets the benefit of limited liability, and just like a sole proprietorship, there is no separate layer of taxation. For this reason, this entity is called a pass-through entity. Just like a sole proprietorship, the founder is not taxed at the LLC level, and the taxes just flow through to the individual owners of the LLC.

LLCs offer a great amount of flexibility, but most VCs will generally avoid investing in an LLC because of this pass-through structure.

S Corp

You may have heard of this idea of an S Corp and wonder, "Well, should I elect to be taxed as an S-Corp?" The answer is almost always no. An S-Corp is essentially a corporation that makes an election with the IRS to be taxed as something called an S Corp. Once the election is completed, it allows the entity to have the features of a corporation but with that pass-through tax structure, similar to an LLC. The challenge with an S Corp is that you are severely limited in the number and types of investors you can have, making it very difficult to scale and seek venture capital funds. For this reason, most venture-backed startups will not elect to be taxed as an S Corp.

For more detailed information regarding Corporations (or C-Corp), please read our article: “Founders 101: Forming a Business Entity in the United States (The Basics)”.

Case-by-Case Review

In the process of establishing a new entity, it is essential to consider a variety of factors that are unique to each situation. The specific type of entity being created, the jurisdiction in which it is being formed, and the overall structure of the entity all play a crucial role in determining the legal, financial, and operational considerations that need to be addressed.

At Zecca Ross Law Firm P.C., we understand the importance of conducting a thorough and meticulous case-by-case review when assisting founders in navigating these complex decisions. Our team is dedicated to providing comprehensive guidance and support to ensure that founders are well-informed and empowered to make the best choices for their ventures.

Whether it involves entity formation, allocation of founder equity, fundraising from investors, or compliance with securities laws, Zecca Ross Law Firm P.C. is equipped to break down the intricacies of these critical issues. Our goal is to help venture-backed startups and their founders successfully navigate the legal landscape and achieve their business objectives.

If you have any questions or require further clarification on the topics discussed in this article, we invite you to reach out to Zecca Ross Law Firm P.C. at contact@zeccaross.com to schedule a complimentary 15-minute consultation. Our experienced team is here to provide the guidance and expertise you need to make informed decisions and set your venture up for success.

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