When you are starting a company, few decisions are more consequential than deciding on the right business structure. It influences your tax liability, the nature of your ownership of the company, your ability to raise capital, and your reporting duties, amongst other things. There is a lot of conflicting information out there about which business structure is best, and why. That’s why we decided to simplify the decision for you. In this quick read, you’ll find everything you need to know about company formation for your startup.
Almost all startup founders decide to set up corporations, and by the end of this article, you’ll know why. But let’s start at the beginning: what are your options?
LLC vs S Corp vs C Corp: The Overview
An LLC is a limited liability corporation: arguably the simplest business structure available. It is easy to set up, not subject to federal corporate income taxes, and has no residency requirements for this members. The LLC is owned by its members, and membership is expressed in the membership agreement (either as a percentage or as membership units).
A C Corp is an incorporated legal entity that is owned by its shareholders, governed by a board of directors, and subject to federal corporate income tax.
An S Corp starts out as a C Corp. Any C Corp can file IRS Form 2553, Election by a Small Business Corporation, with the Internal Revenue Service (IRS). If the corporation meets the requirements (more on that below), it will be taxed as a partnership (i.e. the S Corp itself will not be subject to federal corporate income tax, but its shareholders will be).
The Benefits of Setting Up A C Corporation
This article has no surprising twist at the end. The long and the short of this discussion is, simply: a startup should almost always be set up as a C Corp. Here’s why.
C Corps Offer Significant Tax Advantages to Shareholders
The best way to see why the C Corp is such a dramatically better deal for investors than the LLC is perhaps to start with an explanation of how taxes work for LLCs. With an LLC, the business entity itself is not liable for federal corporate income tax. Instead, the members of the LLC are taxed on the business income generated by the LLC. In colloquial terms: the business income of the LLC flows directly to the members, and they are then taxed on that income.
Exactly how the business income of the LLC flows to the members is determined in the membership agreement. Often, the membership agreement provides that the LLC will allocate cash to its members to compensate them for the income tax that they have to pay. However, even if the LLC does not allocate any cash to its members, the members are still liable for the corporate income tax. This might be a convenient simplification for an LLC with one member, but it is clearly not an attractive deal to potential investors.
Even more importantly: because the LLC’s business income flows to its members, some entities are unable to invest in LLCs. If an entity is tax exempt, it is not allowed to receive business income. Many VCs partner with tax exempt public funds, and can therefore never invest in an LLC. S Corps are taxed similarly to LLCs and generate all of the same problems for this reason.
By contrast, C Corps do not impose income tax burdens on their shareholders. The corporation itself is liable for federal corporate income tax. Shareholders only encounter tax consequences if the corporation pays them dividends, distributions, or salaries. If you are looking to raise capital, you want to ensure investors that they will not be burdened with income taxes. You also don’t want to exclude potential tax exempt investors and VCs that are unable to receive business income. For both of these reasons, you should opt to form a C Corp.
C Corps Make Equity Compensation Easier
Many startups rely on an equity compensation model: you don’t have the cash to pay your employees competitive salaries. Rather, you hunt talent by compensating employees with a stake in the startup: equity. In the case of C Corp, this is an easy and scalable process: you simply grant stock or, more often, stock options to employees.
In the case of an LLC, expanding ownership is complex, expensive, and difficult. And in the case of an S Corp, you are limited to 100 shareholders who all have to be natural persons. It is clear that a C Corp is the way to go if you consider equity compensation.
C Corps Make it Easier to Raise Capital and Grow Your Business
There are a couple of reasons for this. Firstly, Corporations allow for ownership and shareholding structures that cater to the needs of investors (and, for that matter, founders). This includes the possibility of preferred shares that can allow for anti-dilution protection, conversion rights, and the power to elect directors.
Secondly, because members or shareholders are not taxed, corporations can always reinvest cash into growing their business. By contrast, LLCs and S Corps have to use cash to compensate members and shareholders for their increased tax liability.
Thirdly, Corporations allow for flexible ownership. S Corps, on the other hand, have strict rules about shareholding: there may not be more than 100 shareholders, and they must all be natural persons (this immediately excludes VCs as investors – they are almost always Limited Partnerships).
The final reason is the simplest and yet perhaps the most convincing: for all the preceding reasons, investors and VCs do not want to invest in LLCs and S Corps. If you are looking to raise capital, you have to incorporate as a C Corp.
Business Formation Lawyers
So, there you have it: incorporate your startup as a C Corp. You can do it today, with accessible, affordable, and convenient legal assistance from LawTrades. Setting up a company has never been this seamless. Talk to one of our experts today!