How to Choose the Best Legal Structure for Your New Hardware Business
Choosing the best legal structure for your new hardware business is critical. It impacts how much you pay in taxes, your ability to raise funding, the paperwork you need to file, and your personal liability.
Unfortunately, choosing the right legal structure for a hardware business can be difficult given the number of options and their implications.
In this article I discuss five types of business structures with the goal of helping you determine the best options for your unique hardware startup.
Note that all structures covered in this article are specific to the United States. While this information is mostly consistent across many countries, small details may vary. If you reside outside the U.S., be sure to determine the specific regulations for your location.
Rule #1: You are a Business, Not an Individual
It’s very important that you establish yourself as a business. To do so, it’s critical that you have some type of business structure set up from the very beginning.
Unfortunately, many individuals have a great business idea but fail to set up any type of business structure around it. This can negatively affect their credibility, ability to raise funding, and personal liability.
One important and simple step towards establishing yourself as a business is to create a business email address.
I receive many emails from people who use a personal email address instead of a business email because they a) don’t have a one or b) don’t even have a business name.
While I’m a huge proponent of keeping things as simple as possible, not having a business name and email can cause other professionals to look at you as an individual instead of a business. This will ultimately result in your business being taken less seriously.
I highly recommend setting up a business-specific domain name. For example, instead of using YourName@nullgmail.com, use YourName@nullYourStartupsName.com (or whatever your company or business name may be).
While this is not technically part of setting up a business structure, setting up an email is an important step in establishing yourself as a real business which is necessary to facilitate trust and credibility with other professionals.
Also be sure to refer to refer to yourself as the founder of a startup instead of an “inventor.”
In addition to a business email, it’s always best to have some type of business structure set up before you proceed too far on your project.
There are multiple types of business structures that can work for your hardware startup, including sole proprietorships, partnerships, limited liability companies, S corporations, and C corporations. Let’s look at each option in more detail.
Sole Proprietorship
The first type of business structure I want to discuss is a sole proprietorship. This is a business structure for one business owner and it’s automatic.
This means that if you don’t register as any other type of business you are automatically considered a sole proprietor (as is the case for many freelancers, for example).
A major concern with this type of structure is that both you and your business are merged into a single entity. In other words, your business assets and liabilities are not separate from your personal finances.
Unfortunately, this means you have no limited liability and your personal assets are at risk if your business runs into financial problems.
If your business suddenly goes under and you have suppliers that haven’t been paid, for example, these suppliers can come after both your business assets and personal assets, such as your car, house, etc.
I almost never recommend a sole proprietorship for this reason, except when your business is in the very early stages. Once your idea is validated and you’re going to start spending significant amounts of money on your business, I’d highly recommend considering a different structure.
Another negative with a sole proprietorship is self-employment tax. If you have an employer, they typically pay this tax for you. As soon as you go on your own as a sole proprietor, however, the government views you as self-employed and you pay a self-employment tax. These tax contributions basically go towards Medicare and social security.
Despite the negatives, a sole proprietorship is by far the easiest business structure to set up and maintain. Because it’s an automatic structure you don’t have to register your business like you normally would for the other types of structures.
Additionally, taxes are easy to complete. Because you and your business are considered one unit in the eyes of the government, there’s only one tax form to fill out and your personal and business taxes are done together.
Partnership
The second type of business structure is a partnership. This is a simple business structure for two or more people. Partnerships tend to be most commonly used by professional groups like attorneys.
Similar to a sole proprietorship, a partnership is generally not something I would recommend for hardware startups, except in the very early stages.
If you have multiple founders, this could be an early option while validating your product. In most cases, however, I’d recommend going with a limited liability company instead.
Limited Liability Company (LLC)
The third type of business structure is called a limited liability company, or an LLC. There are two fundamental types of LLCs, member-managed and manager-managed.
A member-managed LLC is run by the owners of the company. All individuals can act on behalf of the company. This type is simpler to set up than a manager-managed LLC.
A manager-managed LLC is run by either a single owner or multiple owners. It’s mainly used when there are passive members of the LLC, such as outside investors.
An LLC is basically a combination between a sole proprietorship (or partnership) and a corporation (see more about corporations below). It takes some of the best features of each and merges them together.
Like a sole proprietorship or partnership, profits and losses are passed through to your personal income and you must pay self-employment tax.
However, LLCs have limited liability, as the name implies. This means that your personal assets are not at risk if your business has financial problems.
As you can imagine, this is quite advantageous and it’s one of the main reasons I highly recommend this type of business structure.
Another advantage of an LLC is that they’re relatively simple and inexpensive to set up. The setup is not automatic like a sole proprietorship and you do have to register your LLC with the state. However, it’s fairly simple and typically costs only a few hundred dollars depending on the state.
An LLC is also easy to maintain. This is especially true compared to full corporations that require annual documentation, board meeting notes, and many other complex items, none of which are required with an LLC.
For these reasons, I highly recommend an LLC for all types of businesses, and especially for hardware startups. Even my own business, Predictable Designs, is an LLC.
The only time an LLC becomes somewhat of a limiting factor is once you start to raise outside funding. Doing so is possible with an LLC, but if you plan on raising outside equity-based funding where you sell stock in your company to investors, then you’re going to need to set up a corporation.
S Corporation
There are two primary types of corporations, S corporations and C corporations. This section will cover S corporations.
An S corporation, or S-corp for short, is a full corporation. One main advantage is that it allows your profits and losses to be passed on to shareholders for tax purposes. S corporations also avoid double taxation that can occur with C corporations (discussed in detail below).
Some states have a limit on the amount of profit that can be passed on to shareholder tax returns and this varies from state to state. It’s important to look up the specific regulations for your state if you are considering this type of business structure.
Another advantage of an S corporation is liability. Like an LLC, an S corporation affords limited liability, so your personal assets are protected.
Additionally, even though you can pass profits and losses down through to the shareholders for tax purposes, an S corporation is entirely separate from yourself and personal and business taxes are not merged together. This gives you added protection.
One of the main disadvantages to S corporations is that they have strict requirements.
For example, they can only have a maximum of 100 shareholders and every shareholder must be a U.S. citizen. This could be a limiting factor if you plan to have many shareholders like you would with crowdfunding.
Another disadvantage is that an S corporation involves extensive setup and maintenance, similar to a C corporation.
C Corporation
The last type of business structure is a C corporation (or C-corp for short). C corporations are one of the most well-known business structures and are what most people think of when they hear the word “corporation”.
There are two main advantages to C corporations:
Liability. They afford greater liability than most of the other structures because it’s considered an entirely separate entity from yourself.
Appealing to outside investors. Most professional investors want hardware startups to be setup as C corporations before investing.
Therefore, I recommend setting up a C corporation if you plan on selling stock in your company to raise outside funding (or eventually to exit your company). This is especially true if you plan on crowdfunding because you will have many stockholders or shareholders.
Despite these advantages, C-corps have some disadvantages that are important to consider when choosing your business structure:
Double taxation. As mentioned previously, C corporations run the risk of double taxation and they typically come with higher tax liabilities.
For all other types of business structures, profit gets passed down to you on your personal taxes and you pay personal income tax on that profit.
With C corporations, however, the corporation is first taxed on any profits at a corporate tax rate. Then, some of that profit may be distributed down to shareholders through dividends.
Those shareholders must pay capital gains tax on that profit. Essentially, the corporation must pay tax on profits and then the shareholder must pay taxes on it.
There are many loopholes that corporations can take advantage of to reduce their tax liabilities. Therefore, I highly recommend hiring an attorney if you’re considering setting up a C corporation.
More documentation. Because the profits and losses are not passed to your personal income taxes like the other structures, a C corporation requires its own tax forms.
This means that each year you’ll have to file a corporate tax form in addition to a personal tax form. While this isn’t the end of the world, the added documentation is something to keep in mind when considering this business structure.
Can’t write off losses. Losses can’t be written of on your personal taxes with C corporations and this is especially important for startups.
Hardware startups typically don’t make a significant amount of money over the first few years. In fact, they tend to lose money initially. For all other business structures, these losses can go down as personal deductions, which ultimately lower your personal tax liability.
With C-corps, losses can only be written off against the business’s revenue. If the business is not making any revenue, the losses cannot be written off and you must carry them over into the future.
Once the company eventually generates revenue, the losses can then be deducted. But that’s not when most startups need it the most.
Instead, hardware startups typically need all the financial help they can get in the beginning. Therefore, I don’t recommend set up as a C corporation until after generating significant revenue.
This is a mistake I made with my own company. I started off as an LLC, and when I got to a point where it was finally generating revenue I got a bit over-excited and rushed into setting it up as a C corporation.
The problem was, I didn’t make the revenue that I thought I was going to make until about a year after I set up my company as a C corporation.
For that one year as a C-corp, I was not generating revenue and only incurring losses. I could not pass those losses down to my personal taxes, so I couldn’t get the benefit of writing those off.
That was a very costly mistake on my part. Don’t make the same mistake that I did.
Registering your C corporation
Unlike the other business structures, a C corporation can be registered in any state. It seems like the most obvious choice is to register it in the state that you’re operating in. While this may be true in many cases, some states are more popular than others.
The three most popular states for registering C corporations are Delaware, Nevada and Wyoming, with Delaware being the most popular. This is important to consider when seeking professional investors because they may want you to be registered in one of these three states. But why Delaware, Nevada and Wyoming?
These three states have laws that are favorable for C Corporations. Nevada and Wyoming don’t have any corporate state tax, for example. I registered my hardware startup in Wyoming for this reason.
This can make things complicated depending on where you’re operating and where you’re generating income and you may have to pay taxes in another state than where you’re registered.
If a C corporation is something you are considering for your startup, I highly recommend consulting a legal expert for assistance.
Conclusion
This article has discussed five different types of business structures that can be used to setup your hardware startup. In general, I recommend moving through these structures in the following order:
First, start as a sole proprietor. Stay in this structure for only a few weeks or months while you’re doing your initial research.
As soon as you decide to move forward with your project and plan to invest a significant amount of money, migrate to an LLC. Be sure to do so before you start selling your product to limit your liability and ensure that you’re protected financially.
With an LLC, if your product injures someone and they sue the company, for example, the lawsuit can’t go after your personal income. At this stage I also recommend having product liability insurance as a second means of coverage.
Finally, once you begin to make a profit and if you decide to bring on outside investors, then I recommend switching to a C corporation. Though an S corporation has its benefits, I don’t see this as the best option for a hardware startup.
In summary, start with the sole proprietorship (or partnership if you have multiple founders), then switch to an LLC, and finally to a C corporation.
Other content you may like:
- Lesson 2: The Strategic Way to Develop and Sell Your New Electronic Hardware Product
- Want to Make Millions? Don’t Develop a Product: Do This Instead!
- The First Critical Steps When Bringing a New Hardware Product to Market
- The Key Elements of a Business Plan for Hardware Startups
- Business Models and Recurring Revenue for Hardware Startups
