One of the first questions that I get from many entrepreneurs is “How should I set up my company to minimize my setup costs, tax liabilities and risk of lawsuits?” The answers are different in every part of the world, but the parameters here in the US should give you the considerations you need in any environment. I’ll offer you a few simple rules of thumb.
If you are certain that you are building a large national corporation with more than 100 investors, and multiple classes of stock, then you might as well start with a Delaware or Nevada C-Corp. If you aren’t so sure, need something fast, or need to keep your costs low, then an LLC is the best legal and taxable entity to facilitate your startup. Here are the key steps:
1) Form the simplest legal entity early to cover your efforts. Don’t wait for that first investor, the first prototype, or that first lawsuit. Incorporate your startup after the business plan, but before you spend a dollar on product development. The alternatives include a sole proprietorship, LLC (Limited Liability Company), S-Corp (Subchapter-S Corporation), or C-Corp (US Corporation). While the sole proprietorship is the simplest, it is essentially co-mingling your personal and business assets. The harsh downside is that you might lose your house and all personal possessions if your business fails, or gets sued. Each of the other three has the great legal advantage of limiting liability to the entity-preserving personal assets.
2) Declare a separate taxable entity to optimize taxes. Many entrepreneurs don’t realize that the tax entity election doesn’t have to match the legal entity. For example, an LLC with two or more members (even husband and wife) will default to a partnership for tax purposes, and report income through Schedule K-1. Any LLC or S-Corp can elect to be treated for tax purposes as a sole proprietorship (Schedule C) or partnership (Schedule K). Or any LLC can use Form 2553 Election by a Small Business Corporation to be treated for tax purposes as an S-Corp. Now would be a good time to see your lawyer or accountant if you need more details.
3) The initial paperwork defines the start date of your business. The first step can be done online in a few minutes by filling out Form SS-4 to request an EIN (Employer Identification Number). An LLC or S-Corp or C-Corp requires several more forms to create, and publication in a newspaper. If you do it yourself, this process will likely take a couple of months and cost a few hundred dollars (much more if you use a lawyer).
4) Every startup business needs annual tax return coverage. For corporations, the annual tax return due date is March 15th in the US. LLCs and sole-proprietorships become part of your personal tax-filing package, due April 15th. In addition, corporations have quarterly filing requirements, and even monthly ones, if you collect sales taxes and hire employees.
5) Upgrade your business entity as required. Legal requirements and tax requirements change as a business grows, so your entity needs to be reviewed regularly. For example, you and your partner may be perfectly happy with an LLC, but venture capital or Angel investors may insist on having “preferred” stock, forcing an upgrade to a C-Corp. A few states, like Delaware and Nevada, offer tax advantages to large companies.
If you need help, there are plenty of places you can go online, like the Business USA website. If you are totally confused by the online information, make an appointment with a local agency such as your industry association, your local SCORE office, or your nearest Small Business Development Center (SBDC). If all else fails, hire an attorney to guide you through special cases.
But don’t be misled. Minimizing red tape and taxes is a necessary, but not sufficient, effort to ensure the success of your startup. On the other hand, I’ve seen several innovative and substantial startup efforts derailed by lack of focus on legal or taxation issues. That’s a painful way to die, or wish you had never started.