Now that you have decided to start a company, the first decision you will make as an entrepreneur is the form of business entity to select. As a practical matter, you have three likely choices: a C corporation, an S corporation, and an LLC. Unfortunately, there is no one size fits all solution or a single right answer. The answer to which type of entity to choose is it depends.
As background, all three types of entities, if properly formed and maintained, will provide a measure of liability protection so that if the business fails, you will not have personal liability to creditors (with some notable exceptions). That is where the similarity ends.
A corporation taxed under Subchapter C of the Code is often called a C-corp for short. This is another way of saying that the corporation has not elected the special tax regime under Subchapter S of the Code, as discussed below. The distinguishing tax feature of a C-corp is that it is a separate tax-paying entity. The C-corp pays corporate tax on its earnings. If the corporation then distributes those earnings to its owners (also called shareholders), the shareholders are again taxed (albeit at a lower rate for most dividends from domestic corporations). This is what is meant by the term double taxation that accountants and lawyers regularly use. To avoid this double taxation, corporations will attempt to distribute as much of their earnings as they can in the form of deductible payments, such as compensation. That compensation, however, will be taxable at a rate potentially higher than the dividends would have, and will also attract employment taxes including FICA and FUTA.
If double taxation is the bad news; the good news is that the federal corporate tax rate on C-corps is a flat 21% – the lowest it has been in many years – as opposed to individual tax rates that can be as high as 37% federal (plus state). Importantly, gain from the sale of stock issued by some C-corps can qualify for an exclusion from federal tax as qualified small business stock. Most venture-backed and public companies are C-corps.
Corporations are generally managed by a board of directors, who are periodically elected by their shareholders. The corporation’s rules are outlined in its bylaws. Much of corporate governance is prescribed by law.
A state law corporation (or other qualifying entity) that elects to be taxed under Subchapter S of the Code is called an S corporation. Unlike a C-corp, an S-corp is not generally a separate taxpayer entity. Instead, its earnings pass through and are taxed to the owners (shareholders) pro-rata based on share ownership. Thus, S-corps are sometimes grouped with partnerships as pass-through entities. S-corps differ, however, from partnerships in that the owners can potentially avoid self-employment taxes on the income of the S-corp. Largely for that reason, many closely-held small businesses (and some large ones) elect to be taxed as S-corps. Even Joe Biden famously runs his business income through an S-corp.
A limited liability company, or LLC, is a creature of state law that offers limited liability to all its members but is taxed as a partnership or passthrough unless otherwise elected. As a partnership, its income passes through to its owners (or interest holders or members) similar to the way an S-corp is taxed. Certain types of S-corp income and LLC income can qualify for a special 20% qualified business income deduction. Unlike an S-corp, however, appreciated assets can be distributed from an LLC tax-free. LLCs are governed by an operating agreement and usually managed by one or more managers. LLCs are used in businesses that hold appreciating assets such as real estate and securities and businesses in which the members want passthrough treatment. Also, unlike an S-corp, the income of an LLC will be subject to self-employment taxes.
Which Articles of Incorporation Should a New Enterprise Choose?
This summary illustrates that the choice of entity can be a complex decision. The corporate and tax distinctions between the various types of entities could fill a book, but the new entrepreneur need not get so involved in the details to decide. As mentioned above, most VC-backed companies are C-corps. Thus, as a general rule, a Silicon Valley startup that must raise venture capital to succeed will almost always organize itself as a C-corp. I call these go-big-or-go-home-companies, and they should usually be C-corp. On the other end of the spectrum, the closely held company that will never get near a VC but will throw off many years of a modest but steady annual income will want to consider being an S-corp for the self-employment tax savings. I call these lifestyle companies.
The decision becomes more difficult for companies caught in the middle. They could be a candidate for venture and could be scalable and then exit (advantage C-corp) or they could spend many years earning a small enough profit to make self-employment tax savings meaningful. What should a company do if it is caught in the never-never land of maybe financeable?
The LLC can be a good vehicle to bridge the gap between a lifestyle company and a go-big-or-go-home-company. As an example, a company can start its life as an LLC electing to be taxed as a partnership or an S-corp. If it does not attract venture, it has a tax-efficient passthrough structure that can easily be converted to an S-corp, if desired. If it does attract a venture, it can easily convert to a C-corp to close its deal. It is not a perfect solution as there will likely be some loss of QSBS benefit, and there are complex tax rules that may apply to incorporating an LLC, especially if it has debt-financed losses. There is also the fact that the entrepreneur may have paid for two entities: an LLC and a C-corp. That is the price of delaying a decision and seeing the next card before placing your bet.
Choice of entity is often a difficult decision, but there is a strategy for finding the optimal solution.
About The Author: Roger Royse
Roger Royse is a partner in the Palo Alto office of Haynes and Boone, LLP, and practices in the areas of corporate and securities law, domestic and international tax, mergers and acquisitions, and fund formation. He works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries.
Roger is a Fellow of the American College of Tax Counsel and former chair of several committees of the American Bar Association Sections of Business Law and Taxation. Roger has been an instructor or professor of legal, tax, and business topics for the Center for International Studies (Salzburg, Austria), Golden Gate University School of Law, and Stanford Continuing Studies.
Roger is a nationally recognized authority on agtech – the technology of food production – and the legal considerations for companies in this industry. Roger is also the author of Dead on Arrival: How to Avoid the Legal Mistakes That Could Kill Your Startup and has been interviewed and quoted in the Wall Street Journal, Forbes, Fox Business, Chicago Tribune, Associated Press, Tax Notes, Inc. Magazine, Nikkei Asian Review, China Daily, San Francisco Chronicle, Reuters, The Recorder, 7X7, Business Insurance, and Fast Company. Roger is also a Certified Public Accountant (California non-Attest).