Many founders reach a point where they know they need to "make it official." The common approach: Google "how to form an LLC," file some paperwork online, and assume everything is set.
Then, six months or two years later, some discover the structure they chose is costing them thousands in unnecessary taxes, blocking them from raising investment, or exposing them to personal liability they thought they'd avoided.
Choosing a business structure isn't just paperwork. It's one of the most important legal and financial decisions founders make, and getting it wrong early can be expensive to fix later.
Here are five common mistakes founders make with business structures—and patterns that can help avoid them.
MISTAKE #1
Choosing Based on What a Friend Did
"My buddy started an LLC, so I did too."
"Everyone says S-Corps save on taxes, so that's what I filed."
"I heard you should always start as a sole proprietorship and upgrade later."
Choosing a business structure based on anecdotes, assumptions, or what worked for someone else's completely different business is like picking a legal entity at random.
Why This Creates Problems
Different businesses have different needs. What works for:
- A bootstrapped consulting firm (might thrive as an LLC)
- A venture-backed tech startup (typically needs a C-Corp)
- A side hustle generating $20K/year (perhaps a sole proprietorship)
- A partnership with complex equity splits (benefits from careful operating agreement)
...are completely different structures with different tax treatment, liability protection, investment implications, and operational requirements.
Common Approach Among Successful Founders
Many founders choose their structure based on specific factors relevant to their situation:
- Funding plans - Will they raise venture capital? (Typically requires C-Corp) Bootstrap only? (More flexibility)
- Number of owners - Solo founder? Partners? How will equity and decision-making be split?
- Tax situation - Expected revenue and profit? Personal tax bracket? Plans for reinvestment vs. distributions?
- Liability concerns - How much personal risk does the business create? High-liability industry?
- Exit strategy - Planning to sell in 5 years? Stay small indefinitely? Go public? Each path often favors different structures.
- Investor expectations - Institutional investment typically requires specific structures (usually C-Corp).
MISTAKE #2
Assuming an LLC Automatically Provides Complete Protection
"I formed an LLC, so my personal assets are protected no matter what."
Why This Understanding Is Incomplete
Yes, an LLC (or corporation) creates a separate legal entity that can provide liability protection. But founders sometimes misunderstand what this actually means and what can undermine that protection.
What LLC Protection Generally Means
An LLC typically protects owners from vicarious liability—meaning if the business gets sued for something the business did (contract dispute, customer injury on premises, business debt), creditors generally can't come after personal houses, cars, or bank accounts.
What It Generally DOESN'T Protect
- Personal negligence or wrongdoing - If an owner personally commits fraud, negligence, or intentional harm, they're typically personally liable regardless of structure
- Personal guarantees - Most early-stage business loans and leases require personal guarantees, which pierce the protection for that specific obligation
- Piercing the corporate veil - If owners mix personal and business finances, fail to maintain proper formalities, or undercapitalize the business, courts can sometimes ignore the LLC structure
- Certain types of liability - Some professional liability (doctors, lawyers, accountants) can flow through to individuals even with entity protection
What Many Well-Protected Businesses Do
Founders who successfully maintain liability protection typically:
- Maintain separation - Separate bank accounts, separate credit cards, clear records. Never pay personal expenses from business accounts.
- Follow formalities - Keep meeting minutes (even if sole member), maintain an operating agreement, document major decisions.
- Capitalize adequately - Adequate capitalization combined with insurance. Not forming an LLC with minimal funds while exposing it to substantial potential liability.
- Get proper insurance - General liability, professional liability, errors & omissions, or whatever their industry requires. Insurance is often more important than entity structure for practical protection.
- Avoid personal guarantees when possible - As businesses grow and establish credit, work to remove personal guarantees from obligations.
MISTAKE #3
Forming in the Wrong State
"I heard Delaware is best for corporations, so I incorporated there even though I live and operate elsewhere."
Or conversely: "I just formed in my home state without considering whether somewhere else makes more sense."
Why This Creates Complications
Every state has different formation costs and annual fees, tax treatment and rates, legal protections and business-friendly laws, and compliance requirements.
The Delaware Question
Delaware IS advantageous for:
- Venture-backed startups (VCs typically expect it)
- Companies planning to go public
- Large corporations needing sophisticated corporate law
Delaware is usually NOT optimal for:
- Small businesses operating in one state
- LLCs (Delaware's advantages are mostly for corporations)
- Bootstrapped companies without institutional investors
Example: Delaware + California
If a business forms in Delaware but operates in California, the owner typically pays:
- Delaware formation and annual fees (~$300 franchise tax minimum as of this writing)
- Delaware registered agent fees (~$100-300/year)
- California foreign entity registration
- California taxes (California will typically tax them anyway)
- Two states' annual compliance requirements
This essentially doubles costs with no benefit for many small businesses.
Common Patterns Among Founders
Many small business owners form in their home state when:
- Not raising venture capital
- Operating primarily in one state
- Forming an LLC (not a C-Corp)
- Bootstrapping or staying small
Delaware formation is more common when:
- Forming a C-Corporation
- Planning to raise institutional venture capital
- Considering going public eventually
- Working with sophisticated investors who expect it
For multi-state operations: Many form in the state where they have the most substantial presence or are headquartered, then register as a foreign entity in other states where they have physical presence, employees, or significant business activities.
MISTAKE #4
Choosing Tax Treatment Without Understanding the Trade-offs
"I heard S-Corps save money on self-employment taxes, so I elected S-Corp status immediately."
Or: "I formed an LLC and never thought about how it's taxed."
Why This Creates Issues
Business structure and tax treatment are related but separate decisions, and each has significant trade-offs that depend on specific circumstances.
Tax Structure Overview
Structure
Key Characteristics
Sole Proprietorship / Single-Member LLC (default)
All profit taxed as personal incomeSelf-employment tax (15.3%) applies to all profitSimplest tax filingNo separate business tax return
Partnership / Multi-Member LLC (default)
Profit passes through to owners based on ownership %Each owner pays self-employment tax on their sharePartnership tax return required (K-1s to owners)Flexible profit/loss allocation
S-Corporation (election for LLC or Corp)
Owner pays themselves a "reasonable salary" (W-2 income)Remaining profit distributed without self-employment taxRequires payroll, W-2, separate tax returnPotential tax savings but more complexity and cost
C-Corporation (default for Corp, election for LLC)
Business pays corporate taxesOwners pay personal taxes on salary and dividendsDouble taxation (but lower corporate rate)Typically required for venture capitalCan retain earnings in the company
The S-Corp Consideration
Yes, S-Corps can save on self-employment taxes. But there's a break-even point based on:
- Profit level (needs to be substantial enough to justify salary + distributions)
- Payroll costs (often $1,500-3,000/year for payroll service, varying by provider and location)
- Accounting costs (more complex tax preparation)
- Time and compliance burden (quarterly payroll, filings)
Simplified Example for Illustration (not tax advice)
These examples are simplified illustrations and not tax advice. Actual results vary based on numerous factors.
$50K profit business:
- Sole proprietor: Pay 15.3% self-employment tax on $50K = approximately $7,650
- S-Corp: Pay reasonable salary of $35K, $15K distribution
- Self-employment tax only on salary: $35K × 15.3% = approximately $5,355
- Savings: approximately $2,295
- But payroll costs: approximately $2,000/year
- Net savings: approximately $295/year (minimal benefit given complexity)
$150K profit business:
- Sole proprietor: approximately $18,000 self-employment tax (with income cap)
- S-Corp: $80K salary, $70K distribution
- Approximately $12,240 self-employment tax
- Savings: approximately $5,760
- Minus payroll costs: approximately $3,760 net savings (more meaningful benefit)
S-Corp elections are often discussed as making sense around $60K-80K+ in profit range, though this varies significantly based on individual circumstances. Consultation with a tax professional is essential for determining what makes sense in specific situations.
Common Patterns Among Founders
- Understanding the default - Knowing how their entity is taxed automatically
- Projecting profit - Being realistic about revenue minus expenses
- Calculating break-even - Determining when tax savings exceed added costs
- Considering funding plans - VCs typically won't invest in S-Corps (must be C-Corp)
- Evaluating complexity - Assessing whether they can handle payroll requirements
- Timing the election - Many elect S-Corp status later when it makes sense based on actual profit levels
MISTAKE #5
Going It Entirely Alone on Complex Decisions
"I'll save money by forming my business myself online. It's just filling out a form."
"I'll download an operating agreement template and customize it."
"My co-founder and I trust each other, we don't need all that legal documentation."
Why This Creates Risk
Yes, forming a basic entity is technically simple—formation documents can be filed online in 30 minutes. But the formation documents represent perhaps 10% of the actual decisions and documentation that may be needed.
What Founders Sometimes Overlook
1. Operating Agreement / Shareholders Agreement - This is where governance actually happens:
- How are decisions made?
- What happens if a founder wants to leave?
- How is equity vested?
- What if founders disagree on major decisions?
- Buy-sell provisions
- Capital contribution requirements
2. Equity Structure - Questions about founder equity:
- Different time commitments
- Different capital contributions
- Sweat equity vs. cash investment
- Vesting schedules (particularly important if anyone leaves)
- Future employee equity pools
3. Tax Elections and Planning
- S-Corp elections, Form 83(b) for restricted stock, Qualified Small Business Stock treatment
4. Industry-Specific Requirements
- Specific licenses, permits, or structural considerations for certain business types
5. Intellectual Property Assignment
- Who owns the IP? This typically needs to be documented in writing from the beginning
The Template Limitation
Low-cost online formation services typically:
✓ File paperwork correctly
✓ Provide generic operating agreement templates
✗ Don't explain choices or trade-offs
✗ Don't customize for specific situations
✗ Don't help with equity splits, vesting, tax decisions
✗ Don't identify potential mistakes
Real Founder Example
Two co-founders form an LLC using an online service. No operating agreement, no equity vesting, "50/50 partners."
Six months in, one co-founder stops working on the business but refuses to give up 50% ownership. The remaining founder faces challenges:
- Can't make decisions without partner consent
- Can't remove them without their consent
- Can't raise money with this complicated cap table
- Must buy them out (expensive) or dissolve and start over
This situation could potentially have been prevented with a comprehensive operating agreement including vesting schedules.
Common Patterns in Business Formation
Founders approach business formation at different levels of complexity:
Simple Solo Business (Often lower cost):
- Simple side business, sole proprietorship or single-member LLC
- No partners, no funding, minimal liability risk
- DIY formation + basic templates sometimes sufficient
Standard Small Business (Often moderate investment):
- LLC with basic operating agreement
- Solo or simple partnership
- Straightforward equity and governance
- Attorney review of template or limited scope engagement common
Growth-Oriented Business (Often more substantial investment):
- Multiple co-founders
- Plans to raise investment
- Complex equity arrangements
- Custom operating agreement or shareholders agreement
- IP assignment agreements
- Equity vesting
- More comprehensive legal setup
Venture-Track Startup (Often significant investment):
- C-Corp formation (typically Delaware)
- Sophisticated stock structure
- Founder vesting schedules
- Stock option pool setup
- Investor-ready documents
- Professional counsel from the beginning
Situations Where Founders Commonly Engage Attorneys
- Multiple co-founders (partnership disputes can be costly)
- Raising outside investment
- Complex equity arrangements or vesting
- High-liability business
- Significant assets at risk
- Industry-specific regulations
- Converting from one structure to another
The Structure Selection Process
Common Questions Founders Consider
- How many owners?
- Plans to raise venture capital? (If yes, typically requires C-Corp)
- Anticipated profit level this year?
- State of operation?
- Liability level of the business?
- Complexity they can handle?
Common Starting Points
- Solo, simple business, no VC → Single-member LLC is common
- Partnership, no VC → Multi-member LLC is common
- Venture capital plans → C-Corp is typical
- High profit, want tax optimization → Many consider S-Corp election after profit is established
Planning for Evolution
- Structure can change as business grows
- LLCs can convert to C-Corp when raising VC
- Can elect S-Corp status later when profitable
- Many advisors suggest not over-engineering on day one
Documentation Typically Recommended
- Operating agreement (LLC) or bylaws/shareholders agreement (Corp)
- Equity vesting schedules if multiple founders
- IP assignment agreements
- Clear governance and decision-making rules
Ongoing Maintenance
- Keep business and personal finances separate
- File annual reports/renewals
- Hold meetings and document decisions
- Comply with tax requirements
When Founders Revisit Their Structure
Business structure isn't necessarily permanent. Founders commonly reconsider when:
- Raising venture capital (often convert to C-Corp)
- Profit has increased substantially (may consider S-Corp election)
- Adding partners (operating agreement updates needed)
- Expanding to multiple states (evaluate where formed)
- Tax law changes affect their situation
- Initial structure wasn't optimal for their situation
Steps Founders Commonly Take
Before forming or when fixing existing structure, founders often:
- Assess specific needs - Using the questions above
- Project first year - Revenue, profit, growth plans
- Identify biggest risks - Liability exposure, co-founder issues, funding needs
- Determine complexity tolerance - Whether they can handle payroll and compliance
- Budget appropriately - Factoring in formation, annual costs, accounting, legal fees
Important Balance: Entity selection shouldn't paralyze forward progress—an imperfect structure that can be improved is often better than not starting. But it also shouldn't be treated as a throwaway decision made in 10 minutes.
The Bottom Line
Business structure affects:
- Taxes (potentially thousands per year)
- Personal liability (personal assets)
- Ability to raise funding (VCs typically require specific structures)
- Compliance burden (time and cost)
- Options if co-founder relationships change
One of the most expensive mistakes is choosing based on what's easiest, cheapest, or what worked for someone else, without understanding how it affects a specific situation.
Patterns Among Successful Founders
- Understanding the trade-offs
- Matching structure to their specific situation and goals
- Getting proper documentation (especially with co-founders)
- Planning for evolution as the business grows
- Investing in professional help for complex situations
Investment in proper setup—often ranging from hundreds to several thousand dollars depending on complexity—can potentially save tens of thousands in taxes, legal fees, and complications down the road. Costs vary widely by jurisdiction, complexity, and professional rates.