July 23, 2020
You’ve done extensive market research, written your business plan, picked the perfect name for your dream-come-true, figured out how to fund it, and even found the best location. You are excited and cannot wait to share your vision with the world. The next step is learning how to incorporate your startup.
It doesn’t matter if you own a tiny neighborhood bakery or have ambitions of becoming the future Zuckerberg – each business has to legally establish itself as a company, a legal entity that will handle your employees, own the intellectual property you create, and interact with the customers and vendors.
Incorporating your business as early as possible is essential to protecting your personal assets from any liability of the startup. Your choice in legal structure will impact your business registration requirements, how much money you dish out in taxes, and your personal liability.
There are many obstacles you’ll face as a startup founder. Many new business owners make mistakes early on that cost them dearly down the road. How do you avoid making those rookie mistakes?
Unless you are an attorney or your best friend’s dad is an entrepreneur who founded hundreds of businesses and cannot wait to offer you free advice, the task of finding the right corporate structure for your startup might be extremely daunting. Spend lots of time doing your own research, explore every option available, and educate yourself as much as you can. We will help you decipher some of the legal lingo, but this article should not be taken as legal advice. We encourage you to consult legal and financial professionals who will help you make the best decision on how to incorporate your startup.
So, what corporate structure is best for your startup? The simple answer is: it depends. Just as there are many kinds of businesses, there are also many ways of legally establishing a company – a neighborhood bakery and a would-be Facebook are probably not going to benefit from the same one.
Each company type has its own purpose and advantages. Keep in mind that not every legal entity type is available in every state. In order to choose wisely between each category, you have to ask yourself a few important questions:
Will I Need to Protect Myself?
If your startup will be hiring employees, making purchases, or taking orders for later-date deliveries of the product, you’ll want to create a legal entity that can sign these contracts. The best choice would be an LLC (a limited liability company), that will avoid your personal liability for claims and debts if anything goes wrong.
Will I Be Working by Myself?
If you are in the early stage of setting up a business as an independent contractor and plan on working on projects without partners, a board of directors, or co-founders, you might not need limited liability. In that case, you might not need to create an entity at all. It might be sufficient to file a sole proprietorship or a DBA (“doing business as”.)
Am I Worried About My Short-Term Profits?
If you expect to turn profits in the short term and do not want to be liable for paying both personal income tax and corporate tax, you have a few options. These corporate structures, LLC and S-Corporation, utilize a concept of “pass-through taxation”, which allows income and losses to pass directly to the founder/owner, rather than applying taxes for profits at the company level.
Do I Expect Substantial Growth in the Long Term?
The companies that are structured for long-term growth enjoy a special tax benefit called the Qualified Small Business Stock rule. This rule grants the holders of C-Corporation stock a chance to be exempted from taxation a great portion of the increased value after a certain period of time.
Will I Need Outside Investment?
Many entrepreneurs embarking on high-growth startups see the pass-through taxation as the most important factor, neglecting to look into potential long-term benefits of a C-Corporation. But in a majority of cases, professional investors might stay away from any investment deals with legal entities other than C-Corps, which means that at some point down the road you’ll have to deal with a potentially pretty expensive restructuring of your LLC or S-Corp. The end-game will make all the savings you managed to amass in the beginning of your startup quickly disappear.
Under Which State Laws (Jurisdiction) Will my Company Operate?
After you’ve chosen an entity type, you need to consider where to register it. In the U.S., LLCs and Corporations can be registered in any of the 50 states plus the District of Columbia. You have three options:
Home State. You might think that registering your company in the state where your company has its headquarters would be the most natural option. And if you opt for an LLC, it probably is. But you should think twice before incorporating a C-Corp in your home state. Do your research, as each state has slightly different laws.
Delaware. Most startups are incorporated in Delaware even if they have no commercial operation there. Also, that’s where investors will expect your business to be incorporated. Why? Delaware has a well-defined set of corporate laws that have been formed over the years, particularly because of the reputation of its state court for being efficient and fair with regards to corporate legal matters. But the simple answer is that it’s what everyone in the corporate world is familiar with. One downside to incorporating in Delaware is the annual franchise tax requirement. Some states do not have this, but in general for most startups the franchise tax in the first few years of startups is small (under $1,000.)
Offshore. Setting up a holding company in the Caymans has its advantages as the tax rate may be lower. But you are just starting and thinking of tax rates should not be your priority. Once you start generating revenue that approaches seven zeros we can talk about an offshore entity. FYI, an offshore company almost never makes sense for a U.S.-based startup.
Corporate Entity Types
So, let’s dig deeper into some of these different corporate entities in order to help you choose the best way to incorporate your startup. The business structure you pick will influence everything from day-to-day operations, to taxes, to how much of your personal assets are at risk. You should choose a corporate structure that gives you the perfect balance of legal protections and benefits. The three most common business entities in the U.S. are the LLC (Limited Liability Company), C-Corporation, and S-Corporation. Here’s a quick breakdown:
LLC
LLCs are great if you want that liability protection without all the formality and paperwork. Although it’s very easy and cheap to set up, it does shield you from personal liability as a founder and it is also not subject to corporate taxes. Profits and losses are passed through to your personal income without facing corporate taxes, even though your personal assets are mostly protected in case of bankruptcy or a lawsuit. However, as a member of an LLC, you are considered self-employed and must pay self-employment tax contributions towards Medicare and Social Security. If you are not looking for outside investors, an LLC might be a good choice.
C-Corp
A C-Corp is a legal entity that's separate from its owners. C-Corporations are the norm for most U.S. companies. They have a Boards of Directors, can issue shares as they grow relatively easily, and unlike sole proprietors, partnerships, and LLCs, they must pay corporate taxes. They assume financial and legal liability separate from their founders and stockholders. A C-Corp is the standard entity for start-ups and the preferred choice by venture capitalists as it can take you from conception to IPO (Initial Public Offering.) C-Corps offer the best protection to the owners from personal liability, but they are more costly and complicated to set up and manage. In some cases, corporate profits are taxed twice — first, when the company makes a profit, and again when dividends are paid to shareholders on their personal tax returns. One thing to keep in mind is that if you are looking for investors, they’ll expect you to be a C-Corp. If you apply to a startup accelerator as an LLC, they’ll make you convert to a C-Corp before accepting you. There is one more advantage of choosing a C-Corp as your legal entity - when it comes to raising capital it can raise funds through the sale of stock, which can also be a benefit in attracting employees. Therefore, You better have a really compelling reason NOT to choose a C-Corp.
S-Corporation
The S-Corp, like the LLC, is a pass-through entity for federal taxes, which means that the taxable profits or losses for the business are passed through directly to owners' personal income without ever being subject to corporate tax rates. If you think you’ll make a profit right after the incorporation and will distribute it to the shareholders, S-Corp would be the best choice. You should know that there are special limits on S-Corps. For example, they can't have more than 100 shareholders, and all shareholders must be U.S. citizens. You'll still have to follow strict filing and operational processes of a C-Corp.
On the top of these special limits, S corporations have their own drawbacks for startups, primarily due to restrictions on shareholders. With an S corporation, shareholders must be human beings, or “natural persons.” But many startups take investor money from entities like other corporations or LLCs, so even if your startup began as an S corporation, it would automatically convert to a C corporation the minute you accepted money from an LLC or another corporation. Once your S corporation status is revoked, then you can’t be an S corporation for five years.
Summary
Exploring your options ahead of time will save your time and money, the two most critical resources for every entrepreneur. Corporate structures vary significantly in benefits and protection they provide, as well as in complexity. Starting as the right business entity is the best way to set your company up for success. If you are still asking questions about corporate law, it may be a good idea to reach out to a law firm or startup lawyer to answer your questions.
As always, you’ll want to consult your financial and legal professionals to determine which option will work best in your situation for the long-term.
Sources:
https://www.sba.gov/business-guide/launch-your-business/choose-business-structure
https://medium.com/@tylertate/startup-cheat-sheet-how-to-incorporate-your-company-c85384e8f7a0
