Structuring Your Startup for Success: Choosing the Right Legal Entity and State of Incorporation

How to structure your startup for success when picking a legal entity

By Bradford Toney

Published 2023-03-12

9 min read

Starting a new business may be daunting; however, making the right decision on your business structure and state of incorporation can significantly impact your business’s success and growth. Therefore, it’s essential to take the time to research and carefully consider what would make the best fit for your specific needs and business goals.

Back in 2010, I filed for my first incorporation with Max. We followed online guides on where to incorporate our company. We ended up going with Delaware and filed as a corporation. This was almost certainly the wrong choice for us, but hey, they sent us a really cool seal (that I used on tons of random pieces of paper). Follow along as I dive into my thoughts on where to incorporate now.

Why do I even need to bother with this?

You may be asking yourself, “why is this important?” Tax implications, liability, and management are all fundamental realities that your business may encounter at some point. As such, they are among the key considerations when choosing your startup’s structure and state of incorporation. Understanding the legal and regulatory requirements for different structures and states can help you avoid potential problems and set your business up for success.

Establishing a legitimate entity can also enhance your reputation if you work in an industry where credibility is crucial. Making informed decisions about your business structure and state can create a solid foundation for your startup and increase your chances of long-term success.

Where should you incorporate your business?

The state you choose can have significant implications for your business’s legal and financial status, so it’s crucial to weigh your options carefully. Below I’ll explore some factors you should consider when deciding what state to incorporate your business.

Tax considerations

One of the most significant factors to consider when deciding where to incorporate your business is the state’s tax policies. Some states have more business-friendly tax policies than others. For example, Delaware is a popular choice for incorporation because it has no sales tax or corporate income tax on goods and services sold outside of Delaware. Nevada is another state known for its favorable tax policies for businesses, as it doesn’t have a state corporate income tax. The state also does not impose taxes on corporate shares or franchise tax.

Legal Requirements

Each state has its own set of legal requirements for incorporating a business. Some states, like Delaware and Nevada, have a reputation for having business-friendly legal systems with many corporate protections. However, incorporating in those states can also come with additional costs and requirements, such as annual franchise taxes and fees. Other states, such as California, have stricter legal requirements and higher fees for incorporation.

Business operations

Your business’s physical location and the nature of your operations may also impact your decision on where to incorporate. If your business is primarily online or operates in multiple states, consider incorporating in a state with favorable tax and legal policies. If your company has a physical presence in a specific state, it may be required to incorporate in that state.

Funding and investment

If you plan to seek funding or investment for your business, the state you incorporate in may impact your ability. Some states, like Delaware, have a strong reputation for corporate law and are seen as attractive to investors. Incorporating in a state with a favorable legal system can help build trust with investors and make it easier to secure funding.

Ease of incorporation

The ease of incorporating in a specific state is also a consideration. Some states have a simple process for incorporating, while others may have more complex requirements and higher fees. States like Delaware and Nevada have a reputation for being business-friendly and offering a relatively easy incorporation process.

What’s A Legal Entity?

You might’ve heard the term ‘legal entity’ thrown around before, but what exactly does it mean? Let’s break it down.

A legal entity is a fancy way of saying that your business is separate from you as an individual. This means that your business can enter into contracts, own property, and be sued without affecting your personal assets. In other words, if your company gets sued or goes bankrupt, your personal assets (like your car or house) are protected.

Now, you might be thinking, “What’s the big deal? Can’t I start a business and call it a day?” Well, technically, you could, but that would make your business a sole proprietorship, and while there’s nothing inherently wrong with that, it does mean that your personal assets are not protected. So, if something goes wrong with your business, you could be held personally liable. That’s where legal entities come in.

There are a few different types of legal entities to choose from, including LLCs, S corps, and C corps. Each has its rules and regulations, so it’s essential to research before deciding which one is right for you. However, regardless of your choice, the legal entity you choose provides protection between you and your business.

Types of Legal Entities

Sole proprietorship

A sole proprietorship is the simplest and most common legal structure for small businesses. This structure involves one person owning and running the business. The advantages of a sole proprietorship are that it’s easy and inexpensive to set up, and you have complete control over the company. However, the main disadvantage is that the owner is personally liable for all debts and legal issues that arise from the business.

Benefits:

Easy to set up and operate with minimal legal formalities.
Sole proprietors have complete control over the business and its profits.
No separate tax return is required, as the business income is reported on the owner’s tax return.
Fewer regulations and compliance requirements compared to other business structures.

Drawbacks:

The owner has unlimited personal liability for the business debts and obligations.
Limited access to capital and resources compared to larger business structures.
No continuity of the business after the owner’s death or incapacitation.
Limited ability to attract and retain high-quality employees or investors.

Partnership

A partnership is similar to a sole proprietorship, except it involves two or more people owning and running the business together. Partnerships are relatively easy to set up and don’t require a lot of formal paperwork. However, like sole proprietorships, partners are personally liable for the business’s debts and legal issues.

Benefits:

Allows for shared management and decision-making among partners.
Provides access to a larger pool of capital, skills, and resources.
Partnerships have more flexible tax options, as the business income is distributed among partners and reported on their individual tax returns.
Businesses can form partnerships easily with a simple agreement.

Drawbacks:

Partners have unlimited personal liability for business debts and obligations.
Disagreements among partners can lead to disputes and disruptions in the business.
Partnerships may be more challenging to set up and operate than sole proprietorships.
The death or withdrawal of a partner can cause the partnership to dissolve.

Limited liability company (LLC)

An LLC is a hybrid legal structure that combines the flexibility and tax advantages of a partnership with the liability protection of a corporation. LLCs are popular with small businesses because they offer personal liability protection for their debts and legal issues. Additionally, LLCs are taxed like a partnership, meaning the business’s income is only taxed once. However, LLCs can be more complex than sole proprietorships or partnerships.

Benefits:

Owners have limited personal liability for business debts and obligations.
LLCs offer flexible tax options, as they can be taxed as either a pass-through entity or a corporation.
LLCs are relatively easy to form and operate compared to corporations.
Allows for flexibility in ownership structure and management.

Drawbacks:

LLCs may be subject to more regulations and compliance requirements than sole proprietorships or partnerships.
LLCs may be more expensive to form and maintain than other business structures.
LLCs may not have the same prestige or recognition as corporations.
Ownership and management may be more difficult to transfer or change.

C-Corporation

A C-Corp is a separate legal entity from its owners, meaning the corporation can own assets, enter into contracts, and be sued. The main advantage of a corporation is that the owners are not personally liable for the business’s debts or legal issues. Additionally, corporations can raise capital by selling stock. However, corporations are more complex and have more formal requirements, such as regular meetings and financial reporting.

Benefits:

Provides limited personal liability for shareholders.
Allows for easy transfer of ownership through the sale of stock.
Corporations have access to larger pools of capital and resources.
Provides a separate legal entity with perpetual existence.

Drawbacks:

Corporations may be subject to more regulations and compliance requirements than other business structures.
Corporations may face double taxation on profits, first at the corporate level and then at the individual shareholder level.
Shareholders may have limited control over the management of the corporation.
Corporations may be more expensive to form and maintain than other business structures.

S-Corporation

An S-Corporation allows the business’s income and losses to be passed through to the owners’ personal tax returns, avoiding double taxation. S Corporations are similar to LLCs in that they offer personal liability protection, but they are more complex to set up and have more formal requirements than LLCs.

Benefits:

Provides limited personal liability for shareholders.
It offers a pass-through tax structure, meaning the business income is only taxed at the individual shareholder level.
Allows for easy transfer of ownership through the sale of stock.
Provides a separate legal entity with perpetual existence.

Drawbacks:

S-corporations are subject to more restrictions on ownership and management than other business structures.
S-corporations may be more expensive to form and maintain than other business structures.
S-corporations may need more access to capital and resources compared to larger corporations.
S-corporations may not be suitable for businesses that require significant reinvestment of profits.

Final Thoughts

In conclusion, choosing the legal entity and state of incorporation best suited to your startup is a crucial decision that can significantly impact your business’s success. Depending on your business’s needs and goals, legal entities such as LLCs, corporations, and partnerships offer different benefits and drawbacks. Additionally, the state in which you incorporate can affect taxes, regulations, and legal protections. It is essential to research and carefully consider all options before deciding.

I personally have found that LLCs and S-corporations are usually the better choice for small start-ups/side projects that have turned into something more. Although they cost more, the benefits outweigh the drawbacks, and the process is less cumbersome. Nevertheless, it is advisable to seek legal or financial guidance from a professional, to help you make informed choices that set your startup up for success. Selecting the best-suited legal entity and state for your startup can provide a solid foundation for your business to thrive in the long run.

The information presented here is not intended to offer legal, tax, or business advice, and does not include such guidance. It is important to note that requirements are subject to frequent updates, so it is recommended that you conduct your own research and seek advice from qualified professionals in the legal, tax, and business fields as needed.