Choosing the Best Legal Entity for Your Startup
Should a Startup Founder Set Up a Corporation, S-Corp, or LLC?
Choosing the best legal entity for startups can be one of the most important decisions a founder makes. Venture capitalists will not invest in an S-Corp or LLC, so choosing a corporation is usually the best legal entity for startups. As a founder, selecting a business entity will determine your tax structure, ability to expand in the future, and how you can raise money from investors, so let us help you do it right.
There are three main ways you can establish your business entity as a founder of a startup: C-Corp, S-Corp, or LLC. There are benefits and drawbacks to each type of company, and it is necessary to recognize this to understand why your startup should be a corporation.
A traditional corporation, or a C-Corporation, is a legal entity that exists separately from its owners. It is an incorporated business that is made up of the owners, shareholders, officers, and a board of directors – although one person can fulfill all of these roles and founders are generally all three.
The shareholders own the business through stock ownership, while officers are individuals like the CEO or CFO who operate the business. The board of directors is elected by the shareholders and is responsible for ensuring that officers act in the best interest of the shareholders. This setup is preferable for venture capitalists, as it is easy for ownership and responsibilities to be divided.
One of the most compelling reasons why a tech startup should be a corporation is that it protects the founder and other owners from legal liability. This is the preferred entity type for venture capitalists because if something goes wrong, they will not be personally responsible. For example, if there is a lawsuit against the firm, only business assets can be seized to cover the judgment.
C-Corporations also offer several tax advantages, including eligibility for more tax deductions than other forms of business. C-corps file a business tax return, so the income of the business does not flow through to the individual owners and the tax rate is a flat 21%. Also, owners will pay lower self-employment taxes.
A concern for many founders is the double taxation that occurs when a C-Corp pays out dividends because the individual must pay taxes on that income even though the corporation already has. However, most tech startups will reinvest their profits for many years to promote growth, so this does not apply.
Ease of Raising Capital
The simple division of ownership makes it possible for your company to expand and develop. Since the corporation owns assets like intellectual property, the continuation of the firm is not contingent on the founder’s continuous involvement.
Ownership shares are easily transferable and since venture capitalists want an exit strategy, they are attracted to the fact that they can sell their interests or eventually have an initial public offering. There is no restriction on the number of shares that can be issued, and there can be multiple share classes. This provides a major advantage for raising capital in the future when compared to other business entities.
S-Corp vs. C-Corp
An S-Corporation is structured in a similar way to a C-Corp, as they both have shareholders, officers, and a board of directors. Similarly, both forms of business offer limited liabilities to their owners.
A major difference is that an S-Corp is treated as a pass-through entity for tax purposes, meaning that the owners will claim profits and losses on their personal tax returns. There is no corporate-level tax with an S-Corp, so the business does not file a tax return. This means that the tax rate for S-Corps is not fixed at 21%, so if an owner falls into a higher tax bracket they may pay a much higher percentage.
Another drawback to S-Corps is that it is more difficult to raise capital. Venture capitalists will not invest in an S-Corp because they do not want to be subject to pass-through taxation and prefer the business to pay taxes directly. There are also strict requirements for the shares that an S-Corp can issue. The business can only issue 100 shares, and those owners must be U.S. Citizens or permanent residents thus severely limiting the scope of potential investors.
LLC vs. C-Corp
The third option for organizing a startup is an LLC. An LLC is a registered business that has a very simple structure and is made up of members. Each owns a percentage of membership interest, which represents how much of the company each individual owns. Each member is protected with limited liability, just like a C-Corp.
A major difference between an LLC and a C-Corp is how they pay taxes. An LLC is taxed as a pass-through entity but can elect to be treated as a corporation instead. Similarly, members of an LLC are generally subject to self-employment taxes.
The option for pass-through taxation is not beneficial for tech startups, as founders cannot benefit from passing through losses and venture capitalists will not provide capital if taxes are structured this way.
It is much more difficult for LLCs to scale and acquire capital because they cannot offer stock options. There are also restrictions on the sale of LLC membership interests – venture capitalists like to have an exit strategy so they will not invest in an LLC.
Why Should My Startup Be a Corporation?
When deciding if your startup should be a corporation, there are many things you must consider. Do you want to raise capital by issuing stock, and through venture capitalists? Do you aim to grow your company as fast as possible and scale your business?
If the answer to these questions is yes, a C-Corporation is the best legal entity for startups. There are no limits on the number or types of shares you can issue, and the limited liability and separate taxation offer a huge benefit to shareholders.
We help high-growth startups form corporations across all 50 states, and our experts can help you be certain that you are setting up your business for success. You can get started with the best legal entity for startups on mata now!