Choosing The Best Entity Type for Your Startup
Prior to 2017 when the tax landscape changed dramatically for corporations, the choice of entity decision for any type of company was fairly straightforward for many entrepreneurs. Limited liability companies (“LLCs”) were frequently selected unless the startup already had venture capital funding lined up. LLCs provided a flexible governance structure and often significant tax advantages over corporations that were subject to “double taxation.” Today, however, the tax advantages for certain LLCs have narrowed, and startups must analyze a variety of factors when choosing an entity.
Unfortunately, there is not a “one-size-fits-all” answer whether to use an LLC or corporation (i.e., a C corporation) for a startup company. Professional venture capital firms have historically preferred corporations and, if a startup company is formed as an LLC, a venture capital firm will likely require the startup company to convert to a corporation prior to the firm’s investment. Thus, venture capital firms are a large driver in why startup companies begin as, or eventually convert to, corporations. This is certainly true for financing in Silicon Valley or the East Coast.
Some of the factors given in support of choosing a C corporation for a startup company are as follows:
- Many sophisticated venture capital firms will only invest in the preferred stock of a Delaware corporation. The venture capital firms are comfortable with Delaware corporations, and their familiarity with Delaware corporations can make the investment process more efficient and standardized from deal to deal.
- LLC agreements (or operating agreements in some states) can be complex documents from a tax and governance standpoint compared to a corporation’s articles, bylaws, and related investment documents. Many investors do not like the flexible governance structure LLCs offer and prefer the structured and simpler governance found with corporations.
- Because most investors are familiar with the concepts and variations of preferred stock, raising capital is easier.
- Employees of startup companies are often more familiar with stock options than all of the iterations of equity-based compensation in an LLC. “Profits interests,” the equivalent of a stock grant, are considered much more complicated with an LLC, and require employees to be treated as partners rather than employees for tax purposes.
- Corporations may be able to take advantage of a tax benefit called “qualified small business stock” (“QSBS”) under Section 1202 of the Internal Revenue Code. The status of stock as QSBS determines whether some or all of the gain on the sale or exchange of the stock can be excluded from a taxpayer’s gross income. If stock does satisfy the five requirements for QSBS set forth in Section 1202, 100% of the gain, up to $10,000,000, will be excluded from the taxpayer’s gross income.
- Startups are likely going to reinvest their earnings back into the business, so one level of tax at a flat 21% rather than tax at the individual marginal rates is simpler and could reduce the overall tax burden, freeing up more cash.
- C corporation shareholders are not subject to self-employment taxes on dividends, unlike members of an LLC.
Some of the factors given in support of choosing an LLC for a startup company are as follows:
- An LLC is more tax-efficient because it allows losses to flow-through to its members and investors, allowing for the lowest overall tax rate for investors and the avoidance of double taxation.
- Only one level of tax if the exit is structured as an asset sale rather than an equity sale.
- LLC Agreements are one of the most flexible governance documents for an entity, and its bounds are generally only limited by the imaginations of the drafter and the founders. Thus, LLC Agreements can be drafted to deal with situations that corporation governance documents cannot or that state law does not expressly contemplate.
- LLCs can have “profits interests,” which are a flexible tool for equity-based compensation. Often times, profits interests are used as an analogue to stock options.
- LLCs are able to use the 20% deduction that Section 199A of the Internal Revenue Code provides, which was introduced under the 2017 tax reform.
- It is generally fairly easy to convert an LLC to a corporation at a later date. Alternatively, once a C corporation is chosen, it is very difficult to change to a pass-through structure without tax disadvantages.
One type of entity should be generally avoided: the S corporation. The only real upside to these types of entities is that you can reduce the amount of self-employment taxes on distributions. Other than that one benefit, S corporations often times cause far more problems because they limit the number and types of shareholders a company can have.
Overall, it is best to consult with an attorney or other advisor who has experience in the startup area so they can determine what type of entity is best for each startup’s particular situation based on the factors discussed above and the startup’s long-term plans.
Where to Form Your Company
Once you have decided on the type of entity to use for your startup company, the next decision is where to form that entity. Most of the time, and whether the entity is an LLC or C corporation, the answer will be Delaware. Now you may be asking yourself, “But why Delaware when my company is not located there?” While most people intuitively think you should form your entity in the state where they are based, your home state is not always the best answer.
The advantages of forming your entity in Delaware can be distilled into four main points:
- Delaware has well-established corporate and limited liability company laws.
- Advisory firms know Delaware law.
- Venture capital firms prefer Delaware law.
- Delaware is efficient.
Not only does Delaware have one of the most well-established corporation laws in the United States, it also is home to one of the most utilized and cited limited liability company laws. Furthermore, Delaware is home to the Delaware Court of Chancery—a separate court designed to decide corporate and limited liability company cases, whose judges have expertise in corporate law.
To the second and third factors, picking a state where your legal advisors and investors—particularly the venture capital firms—are familiar will save time and money in the long run. Finally, because Delaware has become the “go-to” state for corporation and limited liability company laws, it is efficient with filing and back-end administrative support. For example, Delaware offers expedited filings and quick-turn around times for many types of corporate filings, which can be very helpful in certain situations.
One downside, however, is that, in addition to forming a company in Delaware, you will then have to qualify the company to do business in your home state. You will also need to pay for a registered agent in Delaware, which adds to the expense. While this entails an additional, yearly capital outlay, the benefits can still outweigh the downside in many circumstances. Ultimately, you will again need to consider the long-term plans for your startup, including whether you desire to seek future venture funding from investors that prefer a Delaware entity, when choosing between Delaware and your home state.
