Forming a legal entity is one of the first big steps for a startup, so if you have reached this stage, congratulations! Now comes the hard part: choosing which type of legal entity to form. Company founders often ask us for advice on the kind of entity they should form. For many startups, making the right decision on the type of entity makes it easier to attract investors and recruit and retain employees. The wrong decision can lead to unnecessary tax burdens, time-consuming legal formalities or roadblocks while trying to attract investors. So what are my options as a company founder? Let’s dive in:
- Limited Liability Company. As the name implies, LLCs limit an owner’s liability and can also offset tax liability of individual owners. LLCs rarely issue stock but instead issue “membership interests” in the company. Of the entities types outlined here, LLCs have the fewest formal requirements for corporate governance and are generally managed by one or more of their owners. As an example, LLCs do not have to hold regular ownership or management meetings (unlike corporations).
- C Corporation. C corporations are the type of entity you hear about the most—the vanilla ice cream of entities. They can issue stock, and there are no restrictions on the number of stockholders a C corporation may have (subject to SEC reporting requirements if the number exceeds 2,000). C corporations have well-defined governance responsibilities, which are held separate and apart from their owners (the shareholders). Management in a C corporation is accountable to the Board of Directors (elected by shareholders) and therefore can transact business without stockholder participation in each decision. However, corporations must follow corporate formalities such as regular board of directors’ meetings, maintenance of corporate ledger and stock ledger books, separate bank accounts from those of the corporation’s board and shareholders and sharing with stockholders.
- S Corporation. S Corporations are “corporations” just like C corporations, but because they have elected a different tax treatment by forming as an S corporation, these entities have a few additional restrictions that set them apart. S corporations are limited to no more than 100 shareholders, all of whom must be United States citizens (and, with limited exceptions, must be individuals and not other business entities). S corporations must adhere to the same governance requirements discussed above for C corporations.
Taxation: Single vs. Double
A big difference between the above options lies in how the entity and its owners are taxed—how much of the company’s profit Uncle Sam gets and many times Uncle Sam gets a cut of that profit. LLCs and S corporations are both known as “flow through entities,” meaning that the business’s profits and losses are passed through to individual members. For instance, if Acme Co. makes a $100 profit this year, that $100 would appear on its owner’s personal tax return. Because Acme Co. would not pay its own corporate taxes, this means that earnings are taxed once. This avoids double taxation. While avoiding double taxation sounds great, one issue often leads to most founders opting for double taxation. The owner of the business has to pay tax on the business income even if they never actually receive the profit from the entity! As you can imagine, it could be hard to pay the tax on a $1 million profit if you never actually received a penny.
C corporations, on the other hand, are subject to double taxation. This means that the corporation’s income is taxed both on the corporate level and a second time at the shareholder level on dividends or distributions. For instance, Acme Co. would file a tax return and pay corporate tax on that $100 profit, and, if and only after that profit was distributed to its owner, the owner would pay tax on whatever amount they received from Acme Co. So, for startup companies that do not pay dividends or generate income at lower tax rates than those applicable to individual stockholders, double taxation may have less of an impact. In addition, if a C corporation generates net operating losses rather than net income, these losses are carried forward to offset future corporate taxable income. However, such operating losses may not be used to offset taxable income of the individual shareholders.
The ability to provide equity incentives—think stock options—to a startup’s future employees are often critical to their ability to attract, retain and motivate employees to help build the business and share in the startup’s success. While all three entity types we’re discussing here allow the granting of options or membership interests, both LLCs and S corporations have restrictions that make granting equity incentives much more difficult.
LLCs may award employees membership interest in the LLC, but the process is cumbersome, limited, may not be attractive to employees and often involves the creation of additional LLC entities. Furthermore, LLCs are not able to offer certain forms of equity compensation available to C corporations, such as incentive stock options. While S corporations may grant stock options to employees, they are restrained by the 100-person limit previously mentioned and such options should not be granted to non-U.S. residents. C corporations, however, have broad discretion in offering incentive stock options to attract and maintain talent, and they can create incentive plans that allow employees to defer paying tax on the incentive compensation until they sell their shares. Finally, C corporations may offer certain fringe benefits to employees that are tax-deductible to the company and also tax-free to the employee, a benefit not available with S corporations.
If you’ve read much on the topic, you’ve likely sensed a pattern: investor preference is a critical factor. A major difference between the entity types is the ability to create separate classes of stock or membership interest, something most investors require before investing. Investors want preferential treatment for getting a return on their investment and protections from liability, as a condition to cutting that check and paying a premium on their stock. Each type of entity has different rules on the ability to create these different classes of stockholders or membership. C corporations are the most liberal in this respect, allowing for the creation of different stock classes with varying levels of preferences, protections, rights and share values. S corporations, on the other hand, allow only one class of stock with equal preference and protections. LLCs generally can only offer membership interests, which limits their ability to build in preferential investor treatment.
Wanting to Attract Venture Capital?
Although LLCs may be attractive to businesses financed by a small number of investors, they are often not suitable for companies planning to attract venture capital or pursue multiple rounds of funding. LLCs require complicated operating agreements that may render the operation of the LLC undesirably difficult with a high number of members. They may also be unattractive to tax-exempt venture fund investors as their investment in a flow through entity may produce “unrelated business taxable income” causing investors to file tax returns or pay tax on the income of their investments. Finally, investors may simply be less familiar with LLCs and therefore less willing to invest in them.
What Should I Do?
Each startup has different needs and will have different reasons for choosing which type of entity to form. As always, we recommend discussing these needs with your attorney to ensure you are making the best choice. Once you have decided what type of entity to form, you’ll then need to choose where to incorporate. For information on that decision, be sure to read our recent post on the subject, “Delaware 101:Why Is Everyone Incorporating There?”.