Startup Focus: Business Formation and Choice of Entity

Startup founders should know the advantages and disadvantages of choosing a certain entity type when forming their companies. Choice of entity involves considerations concerning business direction, liability, taxation, and investment. Startups will generally choose to form as a  C corporation, S corporation, or in some cases a limited liability company (LLC). 

C Corporation

• A C corporation is generally the most popular choice for startups. 
• C corporations can issue multiple classes of stock, which venture capitalist investors prefer. 
• C corporation income does not pass-through to the shareholders, avoiding certain distributions issues. 
• Founders can be considered as employees, avoiding self-employment taxes. 
• Taxation involves salaries, shareholder distributions, and the shareholder's income taxes. 
• There is no limit on on the type or number of shareholders. 
• A C corporation does not have to file a tax status election. 
• Shareholders are generally not subject the state income tax.

S Corporation

• An S corporation can only issue one class of stock. 
• An investor will not be taxed on the company 's income. 
• S corporations have limits on the number of shareholders, non-individual shareholders, and foreign shareholders. 
• A corporation that elects tax status as an S corporation must meet and maintain the criteria set by the IRS. 
• Corporation taxation passes through to the shareholder. 
• Shareholders are generally subject to state income tax, depending on where the S corporation conducts business. 
• In some cases, an individual's tax rate may be higher than the corporate tax rate that is assessed for a C corporation. 

Limited Liability Company 

• A limited liability company is generally the least popular choice for startups. 
• Many venture capitalists will not invest in a limited liability company unless it converts to another entity type. 
• Equity compensation is more difficult than a C corporation, due to the absence of stock classes. 
• A limited liability company's members are generally subject to self-employment taxes, and taxation is based on the share of the company, not distributions. 
• Any income not distributed can result in a basis step-up for interests in the company. 
• A company's losses, deductions, and other benefits can offset an individual tax payment. 

Ultimately, for a startup, a C corporation is generally the best choice. It is easier and more cost-effective to form a C corporation than a limited liability company or S corporation. C corporations are better choice to facilitate equity distribution, investor interest, and reinvestment of capital into the company. 

Every company's formation situation presents unique factors and we can provide you with options customized for your needs. 

For more information or if you have any questions, please contact our Corporate Practice Group.