How to Choose a Business Entity Type for a Tech Business
If you’re entering the world of entrepreneurship with your winning tech business idea, one of the first decisions you’re faced with is the type of business entity to form. The key to selecting the right business entity type is knowing details about your options and the pros and cons of each. The decision is yours, but learning about the options allows you to make an informed choice.
Here you’ll learn about the different business entity types so that you can make the right decision for you.
Sole Proprietorship
If you’re starting a tech business on your own as the sole owner and you simply start doing business without forming a business entity, you’ll be operating as a sole proprietorship. You don’t have to register with your state, and there are no annual reporting requirements. You’ll also have complete control over the management of the business.
A sole proprietorship is considered a disregarded entity for tax purposes by the IRS. This means that the business is not taxed. Profits are passed through to you, the sole owner, to be taxed at your personal tax rate. There is no business tax return to file, and you’ll report the profits on Schedule C of your personal tax return.
The downside of a sole proprietorship is that you and the business are considered one and the same entity, which means that you are personally liable for the obligations of the business. If your tech business owes money to creditors or loses a lawsuit, perhaps because of a fault in your technology, you are personally responsible for paying those debts. This puts your personal assets at risk, including your home.
General Partnership
A general partnership is similar to a sole proprietorship but has more than one owner. No state registration or reporting is required, and profits pass through to the partners to be reported on their personal tax returns. You will, however, have to file a U.S. Return of Partnership Income, which is form 1065, but the return is for informational purposes. The partnership itself is not taxed.
Again, the downside is that you and the other partners are personally liable for the obligations of the business.
If you decide to form a partnership, you should draw up a partnership agreement with the help of an attorney. It should define ownership percentages, how profits are allocated, how disputes are resolved, and contain other provisions.
Limited Liability Company (LLC)
An LLC is a common business entity choice for many tech entrepreneurs because it offers some of the advantages of both a sole proprietorship or partnership, and of a corporation. It requires registration with the state and usually has annual reporting requirements.
Like sole proprietorships and partnerships, an LLC offers pass-through taxation and management flexibility and control.
However, the LLC and its owners, formally called members, are considered separate entities. The LLC has its own obligations, for which the members have no personal liability, hence the name limited liability company. This is similar to a corporation, which is a separate entity from its shareholders.
The combination of personal liability protection, management flexibility, and pass-through taxation is what makes an LLC appealing to many new tech business owners.
C-Corporation
A corporation is a more complex business entity that comes with more formation and management requirements. A corporation must have corporate bylaws and must appoint officers and elect a board of directors. That board of directors must meet the state’s meeting requirements, which generally must occur at least annually.
As mentioned, a corporation and its owners, called shareholders, are separate entities, so shareholders are not personally liable for the obligations of the corporation.
A corporation, however, is subject to corporate taxes at the state and federal levels. The shareholders also must pay taxes on any dividends received, so essentially some of the company’s profits are double taxed.
Shareholders of the corporation who are involved in the management of the company must also be paid a reasonable salary as defined by the IRS before they receive any dividends from the corporation.
The additional administrative expenses that come with the state corporate requirements, and with the required payroll of salaries, make a corporation more expensive to manage.
S-Corporation
A S-corporation is a bit of a complicated caveat. An S-corporation is not a business entity, but a tax status that can be chosen by either an LLC or a corporation. S-Corp status means that your tech company, whether its an LLC or corporation, is not taxed and profits are passed through to the shareholders.
Companies must qualify to be able to elect S-Corp status. The main requirement is that the S-Corp cannot have more than 100 shareholders.
While it’s clear why a corporation might want S-Corp status – to avoid corporate taxes – why an LLC would choose S-Corp status is a bit more complicated.
LLC members who have opted for the default pass-through taxation are subject to self-employment taxes, which fund Medicare and Social Security, at a rate of 15.3%. With S-Corp status, profits from the company are not subject to self-employment taxes. However, S-Corp status means that the LLC is now subject to all corporate requirements, including having a board of directors. Managing members, who are then called shareholders, also must be paid a reasonable salary for the tech industry.
This means that managing an LLC with S-Corp status comes with all the expenses of having a C-Corporation.
So, choosing S-Corp status for your LLC is only beneficial when the self-employment tax savings is greater than those additional administrative and payroll expenses. This generally occurs when your tech company reaches a certain level of income. The decision is complicated and is best made with the assistance of a tax advisor.
Which Is Right for You?
If you want the simplest and least expensive option for your tech business, a sole proprietorship or partnership may be the best choice. However, you will not have personal liability protection.
An LLC offers the best of both worlds, with personal liability protection and pass-through taxation.
However, if you plan to raise money from investors, which is common for a tech company, a corporation may be your best option. The ownership of a corporation, which is in the form of shares, is much easier to transfer to an investor in exchange for capital than the ownership of an LLC. This makes corporations much more attractive to investors.
If you’re not planning to raise capital, an LLC is generally the best choice to protect your personal assets.
Using a Business Formation Service
Many tech entrepreneurs who are forming an LLC or a corporation turn to a business formation service to handle the process of filing state documents. They also often provide other services that can be helpful to new business owners.
When choosing a business formation service, be sure to compare prices and check the reviews of each service.
In Closing
Choosing your tech business entity type is an important decision that can impact the future of your business. Weigh your options carefully to make the choice that’s right for you. When in doubt, consult with your attorney and tax advisor. They can review your situation and your future plans for your tech business and provide critical advice. You’ll want to get off to a good start and give your new tech company the best chance of success.
