Which Form Is Best for You?

Although we discuss the main advantages and disadvantages of different organizational forms, no formula exists for making the determination of which entity is best for your business, and this module's focus on how to obtain financing for your business does not fully address important considerations relating to taxes, personnel, marketing and business strategies, and a variety of other factors that influence your choice of entity.

More details about the tax, personnel, marketing, and operational factors that may influence your choice of organizational form can be found in our discussion of starting your business .

However, certain general principles can be identified to help guide your selection of an organizational form for your small business. For example, many startup businesses follow a progression of organizational forms, evolving from a sole proprietorship into some form of corporate entity as the business's financing needs and options become more complicated. The sole proprietorship is popular for startups because it requires virtually no formalities and no cost to create and maintain, and tax treatment is favorable and simple.

On the other hand, if your business will have employees (creating potential personal tort liability for owners), poses relatively high risks, and/or needs to attract equity financing, the business may benefit from beginning as a corporation. The LLC entity may also be worth considering for a startup business if you want the pass-through tax benefits of a partnership but also want to limit your personal liability. Among the more specific principles to consider are:

Use of equity financing. The degree to which you need to sell ownership interests to raise money for your business will influence your choice of organizational forms. The number and type of equity investors in several of the entity forms are limited. The C corporation allows the greatest flexibility in terms of manipulating ownership interests through the type and number of ownership shares that you sell. However, S corporations and close corporations limit the number and type of shareholders. A sole proprietorship obviously precludes equity financing from anyone other than yourself. Likewise, a general partnership may have problems raising equity capital because adding a new partner requires the unanimous consent of all existing partners. In addition, having numerous partners in a general partnership can create cumbersome management decision-making. LLCs and LLPs are similar to partnerships in this constraint.

Of course, most small businesses do not begin with a large number of owners (e.g., more than ten); consequently, you can usually convert a more simple organizational form, such as a partnership, into a corporation if and when the need for greater equity financing arises.

Risk. If the business has employees, or if several owners will participate actively in the business, the potential personal liability from the conduct of these persons can influence your choice of organizational form. A high-risk business, such as construction contracting, may favor an entity that limits the personal liability of the owners, such as a corporation, limited liability company, limited liability partnership, or limited partnership. In contrast, a sole proprietor and a partner in a general partnership have unlimited personal liability for the conduct of associates and employees.

Taxes. Startup businesses typically experience an initial period of tax losses. A sole proprietorship, a general or limited partnership, an S corporation, and an LLC or LLP will usually allow you to "pass-through" a greater amount of these losses to your individual tax return (unless your interest in the partnership or S corporation is considered a passive activity and your loss deductions are consequently limited). A C corporation would limit the amount of loss you could deduct in any one year to the amount of corporate income for that year (plus any carry-over losses from prior years). In addition, the owners of a C corporation pay a second tax on earnings when corporate revenues are distributed to shareholders.

Image. To some investors, a more formal organizational entity may add to the intangible appeal of your business. A corporate name may create an image of credibility and business sophistication for some investors.

Control. Any entity that has more than one owner involves compromising your exclusive control over the business. Your willingness to dilute your ownership control, and the need to obtain outside equity financing, will govern this factor.

Transferability and marketability. All organizational forms, other than sole proprietorships and C corporations, usually have restrictions on the transfer of ownership interests. Although these restrictions allow the owners a greater degree of ownership control, the constraints are also likely to limit the marketability and liquidity of the equity interests.


Work Smart

For reasons relating to investor relations and financing, it's a good idea to keep investors informed of developments within the business, regardless of the form of entity you elect to use. If you have a number of investors who aren't involved in day-to-day operations, you can mail a shareholder newsletter or periodic correspondence that tells investors what's going on and when the company is planning to do another round of financing. Investors not only appreciate the information, but they often want to participate in further investing.