Incorporating your Startup Venture.
LLC? S-Corp? Delaware? How to choose?
One of the first decisions any startup founder makes is how and where to incorporate. There are several different sorts of legal entities, and different jurisdictions, so which one should you create?
It can seem complicated, but in making this choice there are really just three main drivers for the decision:
- Personal Liability — if the company gets sued can they come after your personal assets?
- Tax Flow Through — are the profits/losses of the company reported on your personal tax return, or does the company file and pay taxes separately?
- Capital Structure — are there shares of stock such that investors can own slices of the company and have certain special rights associated with their stock?
The chart below shows the kinds of legal entities in the US, and the features of each:
Let’s look at them in a little more depth:
- Sole Proprietorship: This is the default under the law. If you do nothing, your business will be a sole proprietorship. Under this structure there is no legal separation between you and the company, which means that if the company gets sued or has debt, you are personally liable. For tax purposes there also is no separation between you and the business, so the business profits (or losses) are just simply part of your personal taxes. There is no equity structure (you can’t sell 23% of yourself to somebody), and no concept of survivability for the business (when you die the business ceases to exist in the eyes of the law).
- Partnership: Exactly the same as above, but more than one person involved with the business.
- Limited Liability Corporation (LLC): Separate legal entity, so you are not personally responsible for the business debts, but there is full tax flow through (the company’s profits or losses go on your personal tax return). Equity structure allows for multiple “members”, but there is no concept of shares of stock to it makes it difficult, for example, for someone to own 3% of the business (and no way to issue stock options or have classes of stock).
- C-Corp: This is the standard “big daddy” corporate structure. Full liability shield (the business is a separate entity so you are not personally responsible for business liability). Separate taxation — the company files its own tax return. Maximum equity flexibility — issue as many shares of stock as you want, sell the stock to anyone (subject to a bunch of SEC laws), have different classes of stock, etc.
- S-Corp: Like a C-Corp except with tax flow-through (eliminates the “double taxation” of profits being taxed at the corporate level and then taxed again when paid out to shareholders). There are also some limitations on the number and types of shareholders, and you cannot have different classes of stock.
- 501(c)3: The standard model for nonprofits (charity) organizations. The profits are exempt from taxation, and individual contributors can get a tax deduction for their donations (subject to certain limitations). Note that as an officer of the nonprofit you can still pay yourself a full market rate salary (subject to standard income tax).
- Benefit Corporation (B-Corp): Recognized by 33 states, a Benefit Corporation’s directors and officers operate the business with the same authority as in a traditional corporation but are required to consider the impact of their decisions not only on shareholders but also on society and the environment. In a traditional corporation, shareholders judge the company’s financial performance; with a benefit corporation, shareholders judge performance based on the company’s social, environmental, and financial performance.
What is the deal with Delaware? In the US, corporations are formed at the state level, not the Federal level. And a strange twist is that most major companies are incorporated in Delaware. The reasons are primarily that (1) the laws are more company-friendly; and (2) if your company ends up in court it will be more efficient to litigate there because the judges are experienced with business matters. If you intend to eventually raise venture funding then you might as well incorporate in Delaware as a “C-corp” because that’s the preference for most investors, but it will increase your cost and administration slightly, because you’ll need to be registered both in Delaware and in your home state.
Summary: There are several things to consider in choosing the right legal structure for your startup. The principle things to consider is whether tax flow-through is advantageous to you, whether you need a capital structure that allows for many shares of stock with different classes and rights.
For a simple business, an LLC gives you personal liability protection without a lot of complexity. But if you plan to eventually raise venture capital, you’ll need to be a C-Corp in Delaware, because that’s the full enchilada version preferred by institutional investors.
This is not intended to be legal advice — consult an actual attorney! Also, please join our special series of livestream panel discussions on legal issues for startups, sponsored by 4thly and Foley & Lardner. Register here.