Starting a new business is exciting, but one of the very first big decisions every founder faces is: What legal entity should I form? This seemingly simple choice has profound implications for liability, taxation, administrative burden, and even future fundraising and exit opportunities. Understanding the various legal structures available is crucial for setting your startup on a solid foundation.
This choice will shape how your startup is taxed, how much liability protection you get, how easy it is to bring on investors, and how much paperwork you’ll deal with. At Slater Cosme, PC, our Pasadena startup lawyers will help you choose a legal entity that fits your business’s needs. Here, we’ll discuss your options and help you pick the right structure for your unique goals.
Why Your Business Structure Matters
Your legal structure affects nearly every part of your startup’s journey. When considering the business structure, you must take certain things into account. If you don’t do this, you may have some hiccups down the road. Here are the top things to consider:
Liability: Can your personal assets be protected from business risks?
Taxes: How will profits be taxed? Once, twice, or not at all?
Investment: Can you issue shares or bring on venture capital?
Administration: What kind of paperwork and formalities will you face?
Growth: How easy will it be to add partners, transfer ownership, or exit?
Picking the right legal entity from day one can save you headaches and money later on. In California, certain legal entities are favored for specific business types. Learning which ones suit your business type correctly will help you in the long run.
Common California Startup Legal Entity Types
Sole Proprietorship
A sole proprietorship is the simplest business setup, where you and your business are considered one and the same. There is no formal filing required unless you wish to register a DBA ("doing business as") name.
The advantages of a sole proprietorship include its ease of establishment and low cost, as well as complete control over the business. However, a significant drawback is the lack of liability protection, meaning your personal assets are exposed to business debts and liabilities. This structure is suited for solo freelancers who are testing ideas or offering low-risk services.
General Partnership (GP)
This legal entity is right for your business if you trust your partners and want a simple arrangement. A General Partnership (GP) is similar to a sole proprietorship but involves two or more individuals. In a GP, partners share profits, losses, and management responsibilities.
The advantages of a GP include its ease of setup and pass-through taxation. However, a significant drawback is that all partners have unlimited personal liability. This structure is suited for individuals who have a high degree of trust in their partners and desire a simple business arrangement.
Limited Partnership (LP)
A Limited Partnership (LP) includes general partners who manage the business and have full liability, plus limited partners who invest money but have limited liability.
The pros of an LP are that it lets passive investors join without risking personal assets. The cons are that general partners are still personally liable, and the setup is more intricate. LPs are common in investment-heavy ventures.
Limited Liability Partnership (LLP)
A Limited Liability Partnership (LLP) offers partners limited liability for business debts and protection from each other's malpractice. However, its availability is often restricted. For instance, California limits LLPs to licensed professionals such as lawyers and accountants.
The primary advantage of an LLP is the liability protection it provides among partners. Conversely, its main drawbacks include its limited availability to certain professions and the requirement for ongoing professional compliance. This structure is typically ideal for professional firms.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is one of the most popular startup entities. LLCs offer liability protection similar to corporations, but with flexible tax treatment and simpler management. The advantages of an LLC include protection for personal assets, pass-through taxation by default, and flexible management.
However, there are some drawbacks, such as an annual $800 California franchise tax, additional fees for higher revenues, and it’s generally not ideal for venture capital. LLCs are a great option for solo founders and small teams seeking both protection and tax flexibility.
Corporation (C Corp & S Corp)
A C Corporation is a traditional corporation with shareholders, directors, and officers. Its pros include raising venture capital, having unlimited shareholders, and strong liability protection.
However, its cons are double taxation (profits are taxed at both corporate and personal dividend levels) and higher administrative requirements. It’s the go-to choice for startups aiming for significant growth and VC funding.
An S Corporation is similar to a C Corp but is taxed like a partnership, meaning profits pass through directly to shareholders. The advantages are avoiding double taxation and offering liability protection.
On the other hand, its drawbacks include limits on the number and type of shareholders, and only one class of stock is allowed. This structure is suitable for small businesses seeking tax savings without the need for extensive scaling.
Professional Corporation (PC)
Professional Corporations, or PC’s, are a specific type of corporation designed for licensed professionals like doctors, lawyers, and accountants to operate their businesses. It offers some liability protection to its owners while still allowing them to practice within the bounds of their professional licenses.
Benefit Corporation (B Corp)
A Benefit Corporation, or B Corp, is a for-profit corporate entity that legally commits to considering social and environmental impact alongside profit in its decision-making. Unlike traditional corporations, which prioritize shareholder value, benefit corporations have a broader focus, considering the interests of various stakeholders like employees, customers, and the community.
Series LLC
A series LLC is a business structure, available in some states, that allows a single Limited Liability Company (LLC) to create legally separate "series" within it, each acting as its own separate entity with its own assets, members, and operations. This structure can offer cost savings and potential asset protection benefits. This type is useful for real estate or IP-heavy startups, but can be expensive in California due to fees.
Factors to Consider When Choosing
Choosing the right legal structure for your startup is one of the most critical decisions you'll make as an entrepreneur. It impacts everything from your personal liability and tax obligations to your ability to raise capital and the administrative burden you'll face. Traverse through the key factors to consider when selecting the ideal legal entity for your business.
Liability Protection
If you want to protect your personal assets from business debts or lawsuits, avoid sole proprietorships and general partnerships. LLCs and corporations offer shields for liability protection.
Tax Treatment
Pass-through entities (sole proprietorships, partnerships, LLCs, S Corps) avoid double taxation by reporting business income on your personal tax return. C Corps pay taxes at the corporate level, and again on dividends.
Fundraising and Equity
If you plan to raise venture capital or issue stock options, a C Corporation is usually the easiest and preferred structure.
Formalities and Compliance
Corporations require formalities like board meetings and minutes. LLCs are more flexible but still require an Operating Agreement and annual filings. Sole proprietorships and partnerships are the simplest.
Consider the Cost
In California, almost every business pays a minimum $800 annual franchise tax except sole proprietorships and general partnerships. LLCs and corporations also face extra fees depending on income.
Ultimately, the right legal structure for your startup depends on your specific goals and circumstances. It's a decision that can significantly impact your business's future, so carefully consider all these factors and consult with legal and financial professionals to make sure you make the most informed choice.
When Should You Change Your Business Structure?
It’s common to start as an LLC or sole proprietor, then switch to a corporation when you need to raise investment or expand ownership. Just be mindful of filing fees, tax implications, and paperwork. Take your time, plan ahead, and build your business on a solid legal footing.
There’s no one-size-fits-all answer, but here’s a simple takeaway: If you’re bootstrapping or running a small, low-risk business, start with an LLC for liability protection and tax flexibility. If you’re aiming for venture capital or rapid growth, go with a C Corporation early on. Consult with a qualified business attorney and CPA to tailor the choice to your specific needs.
Contact Us Today
Choosing the right legal structure is a crucial step that lays the foundation for your startup’s success. Slater Cosme, PC serves clients throughout Pasadena, California, and we’ll help you structure your business in a way that suits your needs and goals. Contact us today to set up a consultation about your new venture.
