Part I: Why you need one, and your options
This is the first of a three-part series on how to set your startup with a Delaware LLC. I recently did this, and will guide you through the process. Let's get started.
Sole Proprietorships are good if you are very small
When you're first starting your business and you're making a few bucks, you don't have to worry too much about getting sued. For one, you may only have a few customers, you're making them happy, and they are paying you. But as time goes on and your customer base grows, it's realistic to expect that something will go wrong.
Perhaps you host websites for businesses and you have a few hours of downtime due to an outage or something similar outside your control. Or perhaps you infringe on a patent you didn't know existed. Or you lose a customer's data that they deemed vital and irreplaceable. By damaging others, even in ways you may consider insignificant, you open yourself up to the greater possibility of a lawsuit.
If your business is a sole proprietorship and your business is sued, the judge can go beyond the assets of the business and a judgment can extend into your personal income and savings. You could lose every penny you have, and perhaps even future earnings. A judgment that your business funds can't cover could even mean having to sell your car or home. The reason a sole proprietorship is so weak in terms of protecting your assets is that a sole proprietorship, by its name, indicates that you are the sole owner. That includes sole owner of the liability and debt. In addition, whether your sole proprietorship's bank account is intertwined with your personal account or not is irrelevant. The business is all you and that's all the judge will see. In a sole proprietorship there is no legal distinction between the owner and the business.
Enter corporations and LLCs
Once you move into the realms of corporations and LLCs, the business transforms into its own entity in the eyes of the law. It is separated from you, and is taxed appropriately. There is a work-around coming ahead, so don't let the tax thing scare ya.
Both corporations and LLCs protect their investors/shareholders/members from liability should the company become a target of litigation.
Read more on Corporations at Wikipedia.
A C corporation has the advantage of having multiple levels of stock: preferred, common, etc. There is no limit on the number of members who can join the company as shareholders. Profits made by the C-Corp are taxed separately from dividends paid to shareholders. Therefore, the corporation is taxed on profits, then the dividends are paid to shareholders, who then pay capital gains taxes on the dividends. This is referred to by some as double-taxation.
C Corporations are typically a better fit than LLCs for startups seeking investors such as venture capitalists and angels, due to the flexible share types. You could always convert to a corporation from an LLC if needed.
In contrast to a C-Corp, an S corporation is not subject to income tax. The shareholders pay tax on their share of the profits. This is similar to an LLC from a tax point of view.
S Corporations can only have up to 100 members and one class of stock.
LLC (Limited Liability Company)
A Limited Liability Company, or LLC, is a special type of business that can have one or many members with voting privileges in the company. There is no limit on the number of members, and depending on the state the LLC was formed, members could be individuals, corporations, and partnerships. Each member is granted either a percentage of the company or a share of the total business units. I'll discuss business units in part three of this series. An LLC has the advantage of pass-thru taxation. It can be taxed like a corporation, partnership, or even as a sole proprietorship, where the taxes are paid easily on the single owner's personal tax form. The method is declared on form SS-4 when applying for an EIN (Employer Identification Number) from the IRS (and if you wish your LLC to be taxed like a corporation, file form 8832). More on this also in part three.
LLCs also have it easy compared to corporations as far as the paperwork and maintenance of the business. Read more on LLCs at Wikipedia.
Delaware LLCs (as more and more states do nowadays) allow for single-person membership. In addition, under the business-favorable Delaware LLC law, LLCs do not have to have annual member meetings. And the paperwork needed to maintain the business is minimal.
Some states such as California have steep annual fees to maintain an LLC. The Delaware LLC franchise fee is only $250 per year.
To maintain a Delaware presence, should you live in some other part of the country, you will need a registered agent. Fees for this can range from around $100 per year to close to $300 per year depending on the agent you use. The agency I'm with costs $159/year. For this you get an agent who will contact you should any paperwork come from the Delaware government or in the event your business is sued. They are your business' representative in Delaware.
Also, Delaware has no sales tax or intangible personal property tax. Delaware also allows the owners and managers of an LLC to remain anonymous.
Whether you decide to go Corporation (C or S) or LLC, you'll find that Delaware is a favorable choice for either.
Legal disclaimer: I'm not your lawyer and I'm not your mom, and you shouldn't believe everything you read on the internet. Make sure you do your own research. And eat your vegetables.
In the next post, I'll go over the first step in protecting your personal assets – separating all your personal accounts from your business. It's vital to do it and do it right, or you may forfeit the legal protections that LLCs and corporations offer.
Next post: Separate your Business and Personal Accounts