The world of software development is famously litigious. For those launching new software startups, the fractious environment can seem a little daunting. Fortunately, there are a number of strategies you can employ to protect your software business, including selecting the right legal form.
The legal form or structure you choose for your business can have a huge impact, affecting not only things like how you report to the IRS but also what resources you have to protect your personal assets. The question is, which legal form is best-suited for success in the software industry?
Choosing the Right Legal Structure: Exploring the Options
There are a handful of options to choose from, including Sole Proprietorship, Partnership, Limited Liability Company (LLC), and Corporation.
Sole Proprietorship
When you first start generating income on a self-employed basis, you’ll automatically be considered a Sole Proprietor, which does not provide any built-in form of personal liability protection. Sole Proprietorships are not distinct legal entities, meaning there is no distinction between you and your business. So, if the business is sued, it means your personal assets are very much on the table.
Now, there are some clear advantages to the Sole Proprietorship format, such as overall flexibility and light regulatory burdens. But sheerly, in terms of liability protections, this isn’t the best fit for growing software companies.
Partnership
A Partnership works very similarly to a Sole Proprietorship, only it involves you enlisting one or more partners to share in the profits as well as the day-to-day operation of the business.
For our purposes here, it’s simply worth noting that the Partnership, too, fails to offer any real liability protections. In terms of shielding your interests within a litigious industry, this probably isn’t the best option.
LLC
One of the most popular legal forms for small business owners is the LLC. Unlike the previous two options, registering your business as an LLC actually does create a distinct legal entity. In other words, you can maintain a clear separation between your business assets and liabilities, and your personal ones.
This is important because it provides a significant level of personal wealth protection. Litigation and creditors may threaten your business assets, but not your personal retirement accounts, family nest egg, and so forth. As such, registering as an LLC allows you to confidently invest in your software business, understanding that you can still shield personal assets and limit any financial losses you incur.
There are a number of other advantages to the LLC format, as well. Some examples include pass-through taxation, enhanced professional credibility, and greater access to business loans and lines of credit. The downside: There is a bit more regulatory upkeep involved here, compared with the previous two options… though not as much as the fourth and final option.
Corporation
A final way to structure your software business is by incorporating. A Corporation does involve some robust personal liability protections, equal to what you’d expect from an LLC.
But there are also some downsides, mostly pertaining to heightened regulatory expectations. For example, you will be required to create corporate bylaws, issue shares, and hold annual shareholder meetings. Public reporting is also a big deal. There’s also the reality of double taxation, a major knock against Corporations.
This is the best option for software entrepreneurs who wish to go public one day, or who desire access to outside investors and venture capitalists. Otherwise, the LLC is generally regarded as the best middle-of-the-road approach, allowing you robust personal liability protections but also a lot of flexibility and ease.
How to Register Your Software Business as an LLC
There are a few steps required to formally register your software business as an LLC. The specifics can fluctuate by state, but here is a general overview.
- Choose a state for registry. Although it is technically legal to register in the state of your choosing, those who have a US-based location will always just want to register locally. Forming an LLC in New York when you’re based in California just leads to tax headaches.
- Pick a name for your LLC. Every LLC is legally required to have a name that is unique, distinct from any other LLC in the state. Usually, there will be a searchable online directory available, making it easy to determine whether the name you want is still available.
- Appoint a Registered Agent. Your Registered Agent’s job is to receive tax and legal documents on the business’ behalf. You can pick an individual or an organization, just as long as they have a physical mailing address in the state where you are registering your software LLC.
- File Articles of Organization. This is the document that must be filed with the Secretary of State to formally establish your software LLC. You will also need to pay an LLC filing fee, which may be up to two or three hundred dollars in some states.
- Create an Operating Agreement. Your Operating Agreement serves as a charter for your business, outlining how it’s run day-to-day. Legally, you don’t have to have one. However, an Operating Agreement can help you minimize friction and conflict down the road, so it’s prudent to have this document in place.
- Claim an EIN. You can get an Employer Identification Number free from the IRS. You won’t need it right away, but you will need it before you can process payroll or file your taxes.
With these steps, you’ll be ready to take advantage of the personal liability protections that the LLC format can provide.
Protect Your Software Business by Choosing the Right Structure
As you think about legal protections for your software business, choosing the right form is critical. And while there is no one right answer across the board, a majority of businesses will benefit from choosing an LLC. Talk with your business attorney if you have any additional questions about registering your software business as an LLC.
