The entity you choose matters. Here’s a cheat sheet on entity selection considerations, including a reference chart.
WHO? Founder(s) of a new business…
WHAT? …should file a certificate to form a business entity…
WHERE? …with the Secretary of State’s office in the state of formation…
WHEN? …prior to conducting business…
WHY? … for many reasons, including credibility, fundraising, personal liability and taxes.
Most new businesses will choose an entity from these three options:
1. C-Corporation (C Corp);
2. S-Corporation (S Corp); or
3. Limited Liability Company (LLC).
Here's a bit about each and why this decision is a critical one in the life of a business.
The C Corp (Inc.)
Profile: Used by developed companies requiring a more complex capital structure.
- Flexible Ownership: C Corp’s can have an unlimited number of shareholders, different classes of stock, including preferred stock (key for VCs), and are the preferred entity for equity financings, acquisitions, etc.
- Compensation with Stock: C Corp’s are also aligned with the tax code to efficiently issue traditional equity compensation, for example, stock options..
- Taxation: Shareholders do not pay taxes on corporate income unless there is a distribution. The C Corp pays its taxes separately from the shareholders.
- Predictability: Law is well-established regarding structure and functionality. (Delaware is preferred as the state of incorporation by many institutional investors)
- Double Taxation: C Corp’s are subject to “double taxation” – the company’s income is taxed at the corporate level, and after that shareholders pay income tax on any distributions they receive from the company.
- Corporate Formalities: C Corp’s (and S Corp’s) have more statutory obligations, including filing and voting rules, than LLCs.
The S Corp (Inc.)
Profile: Used by companies with a simpler capital structure seeking pass-through taxation.
- Taxation: S Corp’s profits are only taxed once, at the shareholder level. The S Corp provides the desired limited liability but its income “passes through” the corporation directly to its shareholders. Like income, S Corp’s losses generally pass-through to the shareholders and can offset other income.
- Predictability: Law is well-established regarding structure and functionality.
- Limited Ownership: S Corp’s shareholders must be individuals (not entities) who are US residents or citizens. And there may be no more than 100 shareholders.
- Structure: S Corp’s may not have multiple classes of stock. For example, preferred stock is not permitted.
- Compliance: The company must elect S Corp status through an IRS filing and monitor its structure on an ongoing basis to ensure compliance and maintain such status.
Profile: Used by companies of many different types, structures and sizes.
- Structure: Allows for flexible capital structure and ownership.
- Taxation: The LLC’s income is only taxed once, at the member (aka shareholder) level. The LLC’s losses generally pass-through to the members and can offset other income. More certainty in pass-through tax status, compared to the S Corp and fewer corporate formalities to observe.
- Investor Relations: Generally less attractive to institutional investors due to complexity of operating agreement and other functionality issues.
- Employee Incentives: More complicated to implement equity incentive programs such as stock options.
- Predictability: Laws for LLCs are less developed than for corporations.