Should I form an LLC, C corp, S corp, or LP for my business?

When it comes to owning a business and forming an entity there are many options. So in this post I’m going to walk through the main types of entities - LLC, C corp, S corp and LP - and explain what they’re best for.

Incorporation is not necessary to run a business, and indeed many of the Etsy craft sellers make and sell their goods and pay taxes on their personal returns.

Three Main Reasons to Create an Entity

First, there are three main reasons to create an entity: liability, taxes, and outside investment. The kind of entity you choose will depend on which of those is important to you. Which one do you care about most?

Before going through them, a disclaimer: I am not a lawyer or tax professional; you should consult both an attorney and a tax professional before considering incorporation. Experts are welcome to comment on this post, particularly those who wish to contradict anything said here. This is about US law only; it does not apply in other countries.

So, with that disclaimer out of the way, lets get rolling!

Business ownership is not just about you. A business, given time, will take on a life of its own: it will have other owners, it will have its own debts, and it will have its own tax bill.

Creating a company is acknowledging that separation - it is a buffer between you and the business.

So, liability: the company can limit your exposure on the bills the company owes (accounts payable, aka invoices you owe to other people) and other promises (such as services - can you deliver them?), and lawsuits - anything the company is expected to do. This is extremely important. Nobody is expecting you to put your family at risk, and most lawyers would advise you to incorporate your business as soon as possible.

Taxes: there are ”flow through” entities where income and tax pass through to the owners (for example, the local restaurant). Then there are ”tax paying” entities where the company pays taxes (for example, Google). You own a 100 shares in Google. You are not going to get a tax bill. Google is going to pay its own taxes. Now, lets say you own 100 ‘Local Restaurant’ shares, and that the restaurant doesn’t pay taxes, but all the income ‘flows through’ to you. It means that the restaurant didn’t pay any tax, but you’re getting a tax bill for all the profits ‘your’ restaurant made.

And ”investment”. If you want to split a business 50/50 with a partner you will need an entity. And if you want to take an investment in your business from a third party, your business will need an entity that issues shares or membership interests. Creation of an entity is how you divide up ownership of the business, investors put in money and get a share in the business (or a membership interest) back.

The Actual Entities

Next the actual entities: one at a time: LLC, C corporation, S corporation, limited partnership.

LLC (Limited Liability Company): Has been very popular in the US for the last 25 years. LLCs have existed outside the US for many years. LLCs are what most startups start as, and probably the first one you’ll encounter if you are in the US. LLCs give you a liability shield (like a corporation) but they have the taxes flowing through. The owners are usually called ”members”, they have ”membership interests”, and you can take investment in them, but there are restrictions.

C corporations: most VCs want to invest in a C corporation. Venture-backed companies usually convert to c corps. C corps allow more sophisticated ownership and more sophisticated fundraising. Most of the large US public companies, like Google, Apple, GE, are C corporations. Now, another feature of a C corporation is that C corporations pay taxes. That’s important too, that it pays its own taxes, the founders don’t pay its taxes.

Why do VCs want C corporations? The pass through taxes of LLCs makes them a pain for VCs, especially those with foreign investors. The governance systems around LLCs are less well developed than C corporations. My opinion: LLC is ideal for a small, closely held company, but when it gets big and complicated, then C corp. The c corp stuff gets really complicated really fast, don’t try it alone.

Another type of entity is the S corporation, and that’s another type of flow-through entity. One type of stock, less than 100 shareholders, flow through tax, easy to set up. But, in the long run, LLC is more flexible than S. I think if you’re going to be long term flow through but you’re going to have a lot of shareholders, an LLC is better than an S corp.

Another type of entity is the Limited Partnership, also known as the LP. You’ve probably heard of Bloomberg LP. The investors get limited liability, but not the general partners (that’s important). The General Partners manage the company and also carry the liability. It’s built for outside investment, and the taxes flow through.

There are of course many other kinds of entities, but these describe the basics of how entities differ depending on liability, ownership and taxes.

Start Simple

Business advice for new founders: form an entity to contain risk and protect your family. Start simple and change the form of your entity as your business grows and investors and partners arrive.

Additional advice to investors: you should understand the type of entity you’re investing in, your liability exposure, and the tax consequences of that investment.

Finally, you’ll want a lawyer, and a tax advisor, and they’re expensive, but a good one is worth it.