Entity Type
Deciding which structure is best depends on a number of key factors:
- limited liability of owners
- ownership/management
- ease of issuing equity-based compensation
- future fundraising plans
- taxes
Corporations and Limited Liability Companies (LLCs) are the preferred entities for start-ups because of the limited liability protection they afford owners.
For start-ups that have raised (or intend to raise) money from venture capital investors or other institutional investors, the corporation is a popular structure.
What is a C Corporation?
A C corporation is the most frequently utilized formation vehicle, particularly for companies that anticipate seeking venture financing, for many reasons including unlimited growth potential through the sale of stock, which means there is a possibility of attracting wealthy/institutional investors.
Advantages of C Corporations
They have limited liability, which applies to officers, shareholders, directors and employees.
There is no shareholder limit, but they are required to register with the SEC once the company has reached $10 in assets and 500 shareholders.
They have certain tax advantages, including a lower tax rate (currently) and more allowable tax deductible business expenses.
Disadvantages of C Corporations
They may have higher formation costs.
Shareholders cannot deduct losses on their personal tax returns like shareholders of an S corporation or LLC can.
They are subject to double taxation on dividends/distributions or asset sales.
LLCs: are pass-through entities that generally are not subject to a separate level of tax and can provide founders with lots of flexibility when it comes to governance and capital/equity structuring. On the other hand, because of the greater degree of flexibility, LLC structures may often be much more complex (and increased complexity typically also correlates to higher legal/transaction costs), and certain venture capital funds are hesitant to invest in LLCs because of tax considerations and the aforementioned complexity.
What is an LLC?
A limited liability company, or LLC, is a pass-through entity that is generally not subject to a separate level of income tax and can provide founders with greater flexibility when it comes to governance issues.
Advantages of LLCs
They have limited liability, which applies to officers, shareholders, directors and employees.
They offer strong privacy protection.
They allow for more tax flexibility, a single layer of taxation and potential flow through of losses.
They are easier to form due to lower formation costs.
Disadvantages of LLCs
Limited investor appeal means that most big investors prefer to invest in corporations over LLCs, making funding more difficult.
Fees and taxes in some states require LLCs to pay annually or semi-annually to conduct business in the state. These can either be flat fees or fees based around what the business is making or the income of the company.
The transfer of business ownership can be more difficult due to no shares of stock.
What is an S Corporation?
A subchapter S corporation offers pass-through treatment similar to an LLC if certain requirements are met. This type of corporation only has one class of stock and cannot have more than 100 shareholders within the business.
Advantages of S Corporations
They generally offer a single layer of taxation (i.e. pass-through taxation) while providing simpler corporate structures to issue stock options or other equity-based compensation to service providers.
Disadvantages of S Corporations
It is difficult for an S corporation to gather cash reserves since shareholders typically receive distributions to pay taxes on the income, which has been passed through to them at a higher rate of taxation.
Only natural persons can be shareholders of an S corporation.
Not all jurisdictions recognize S corporation treatment (certain states and most local jurisdictions do not).
Additionally, if a principal purpose of your start-up is to provide a material positive impact on society and the environment, then you may wish to form a Benefit Corporation, which is generally subject to the same corporate laws as other corporations but differs in terms of purpose, accountability and transparency.
