Most startup companies’ first legal question is what type of business entity should we form? Many professionals commonly improperly answer this question because there are many factors that shall be determined prior to choosing the appropriate business structure. This article will explain some of these factors.
When a client comes to my office in order to incorporate their business, I know from the top of my head that the three most common business entities in the United States are the C Corporation (“C-Corp”), S Corporation (“S-Corp”), and Limited Liability Company (“LLC”), however some states still do not have the LLC structure as an option. Usually my first few questions to these entrapanuers are, what type of business are you? (For example, are you a fashion company or an IT company or etc.?) And are you planning to get outside investors? The reason for these questions is because I need to understand the company’s goals and business dynamic. If a company is small and does not plan to go public or have outside investors, an LLC structure is usually the best option. The reason it is the best structure is because it provides liability protection without formalities and having to do a lot of paperwork. In addition, LLC’s are considered “Pass Thru” entities for tax purposes, meaning that the taxable profits or losses for the business are passed thru to the business owners, who record these as part of their personal income tax filings. The LLC does not pay corporate taxes for profits and does not accumulate losses for future tax offsets. Hence, the owners of the company are only taxed once.
On the other hand, C- Corps are taxable business entities, meaning that each year they must report their profits/losses and pay taxes (state and federal) when they make a profit, and record a tax loss carry forward when they have a loss. Shareholders in C-Corps have no tax implications from profits or losses as a result of owning shares in the entity, and would only have to pay taxes if they were to receive a dividend payment from the company or were to sell their shares for a profit. The primary negatives for C-Corps is that they are somewhat more costly to maintain from a legal and tax filings perspective, and face “double taxation” when distributing profits to shareholders. Double taxation in this context means that C- Corps pay income taxes on income generated by the business, and stockholders pay taxes again when they receive dividends on their stock or sell their stock.
If a company is planning on obtaining outside funding and/or going public, incorporating as a C- Corp is probably going to be the best option. For example, typically LLC’s are not great for tech startups for a few reasons; (1) LLC’s cannot issue convertible preferred stock, the typical vehicle for a venture capital investment. Only C- Corps can offer this; (2) the tax partnership guidelines are very complicated; (3) it doesn’t allow for stock option plans, convertible notes, etc., (4) it gets more expensive and complicated down the road.
Another structure is an S-Corp. For a company to become an S-Corp, a business would need to initially incorporate as a C–Corp and then file an S-Corp election with the IRS, comply with any IRS qualification requirements (e.g., limits on the number of stockholders and who your stockholders are) and comply with any corresponding state filing or qualification requirements. A company may prefer to become an S-Corp because S-Corps have the benefit of avoiding double taxation just like LLC’s, but come with limitations that generally make the benefits unavailable to venture-backed companies. In some cases, startups will file an S-Corp election, and when they raise a round of venture capital, they will automatically lose the status as an S-Corp and revert to a C-Corp. Comparably, if a business owner chooses to file for an LLC initially, they can later convert this into a C-Corp if they choose to.
In addition to all of the foregoing factors, a company owner(s) need to decide in which state they want to incorporate. Since there is no legal requirement for a business owner to form their new corporation or LLC in their home state, this broadens the factors one must contemplate when incorporating. Generally, if a company is small and is not looking for outside funding, it is recommended that they incorporate in their home state, unless, other factors direct otherwise. Many large companies that do obtain outside funding or go public prefer incorporating in Delaware. The reason for this preference is due to the fact that Delaware is a business tax-free state, which excludes taxation on corporate income tax, taxes on corporate shares and franchise tax. In addition, it has a very efficient court system that favors businesses and corporate law.
In conclusion, this article should be a good guideline to give you an idea about which type of business entity to form. Nevertheless, there are other factors that can play a huge part; therefore, you should consult your attorney or accountant to make sure that you make the right decision.