Should I incorporate my startup as an LLC, an S-corp or a C-corp?

Besides obtaining finance to get your new business going, one of the other important things that you need to get right is how you’re going to incorporate it.

There are three options. An LLC, S-corp or a C-corp. But before you go ahead, you need to ensure that you choose the one that best serves your needs both now and in the future. Yes, you can make a switch at a later stage, but that comes with a lot of hassles.

In this article we will unpack the differences between all three options so that you can make an informed decision.

Before we dive into the differences, here’s a straightforward table outlining the three business structures and their meanings.

What is a Limited Liability Company?

If you want to apply for government grants, subsidies, or business loans, and participate in various small business or startup programs in your area, an LLC makes sense.

You may be satisfied with running your venture as an LLC for years, or indeed forever, but depending on your situation and goals, you may also find your business to be growing out of it, meaning that you need to re-incorporate.

What are the positives of a Limited Liability Company?

LLCs allow you to do business as a company, to invoice customers, open a corporate bank account, hire contractors or payroll employees, apply for business loans or grants, and pay favorable corporate taxes on profits. As a general rule of thumb, they are better suited for small businesses not looking for external funding.

One of the main reasons for their popularity is that they offer limited liability protection to business owners. A sole proprietor is personally responsible for the company’s debts and legal claims, putting their personal assets at risk. But by forming an LLC, the business owner can protect their personal assets from business liabilities.

Other benefits include favorable and flexible tax policies as profits are only taxed once at the owner level, a simplified corporate structure with fewer management layers, and, importantly, enhanced business credibility.

Something worth noting is that when incorporating as an LLC, the best place to do that is likely to be your home state or where your company is actually physically based. The advantages of some states known for stable and reliable bodies of corporate law or low or no taxation rates for corporate taxes may only apply to corporations, not to LLCs.

What are the negatives of a Limited Liability Company?

It may be difficult to raise outside investment capital as an LLC as it’s not possible to sell shares of an LLC and to have stockholders. So it’s not attractive to VCs.

There are workarounds for everything, of course. You can have members who are granted rights to split profits with you, which can help you attract capital and employees to your business even if membership is not tradeable in the same way that shares in a corporation are.

If you are seeking larger rounds of institutional capital, such as from venture capital or private equity funds, such funds will generally insist that you incorporate your venture as a joint-stock company that is able to issue shares as an S-corp, or more likely, a C-corp.

What is an S-corp?

An S-corp is a type of corporation that elects to pass corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes.

To incorporate as an S-corp there are a few boxes you must tick. You must be a domestic corporation with no more than 100 shareholders who are all US citizens and they must be individuals, certain trusts, or estates. And, you must have only one class of stock (no preferred stock).

Important to note, though, is that not all states allow S-corps. Massachusetts, New York, Michigan, California and New Jersey may all tax S-corps double above a certain dollar threshold, or for all taxes at the state level.

What are the positives of an S-corp?

An S-corp allows the same pass-through taxation that an LLC does, potentially saving you tax dollars if your company is profitable – which may not be a problem that an early-stage startup has.

Rather than being taxed first as a company and then on your income or dividends, taxation can pass through to the owner’s personal tax return. Due to the 2017 Tax Cuts and Jobs Act, S Corp shareholders can deduct up to 20% of their Qualified Business Income (QBI), potentially lowering their individual tax burden by 20-25%.

But this may not be important if your company is not earning enough income to pay significant tax. An S-corp can only issue common stock, and a change of majority ownership could potentially end its eligibility for S-corp status.

In addition to providing tax savings, the S-corp structure safeguards the owners’ personal assets from lawsuits or debt collections targeting the business.

What are the negatives of an S-corp?

As mentioned above, although an S-corp is a popular business structure due to its tax advantages and liability protection, these advantages are balanced by eligibility constraints, compliance requirements, and limitations in raising capital and flexibility. So, business owners need to carefully consider whether these limitations align with their business goals and future growth plans.

Passive income limitations: If an S-corp’s passive income (including rents, royalties, dividends, or interest) exceeds 25% of its gross receipts for three consecutive years, it risks losing its tax status.

Difficulty in raising capital: Since S-corps are limited to issuing only one class of stock and have restrictions on the number and types of shareholders, raising capital from investors is more difficult compared to C-corps, which can issue various types of stock and attract a wider range of investors.

Transfer restrictions: Transferring ownership in an S-corp can be more complicated than in other business structures because of the strict eligibility requirements for shareholders.

What is a C-corp?

A C-corp, named for its classification under subchapter “C” of the IRS code, is a distinct legal entity owned by shareholders and designed for unlimited growth. Many large businesses and publicly traded companies opt for this structure because it allows for expansive growth through stock sales, making it attractive to investors and well-suited for large, retail-oriented enterprises.

Obviously all founders want to grow their companies, so important to note is that they offer unlimited growth potential as you can issue an unlimited number of shares, making it easier to raise capital through the sale of stock.

What are the positives of a C-corp?

C-corps allow you to issue an unlimited number of shares and multiple classes of shares, such as common and preferred stock, to an unlimited number of shareholders who don’t need to be citizens.

It’s more straightforward than the pass-through taxation of LLCs or S-corps, as in a C-corp the company pays corporate tax at the corporate level, rather than passing the tax burden through to the tax filings of its individual members.

C-corps are also the preferred form of venture capital funds, so if you are seeking to raise a financing round from VCs, you may want to prepare for that by making the transition.

Venture capitalists typically prefer C-corps over LLCs because of the way they’re taxed. An investor in an LLC could be taxed even if they don’t receive any distributions from the company – and VCs don’t like that! With C-corps, investors are only taxed if they sell their stock or receive distributions from the company (like a dividend) – that’s why VCs prefer them.

Also, investors – especially VCs – will generally only want to invest in Delaware C-corps. That’s because the laws in Delaware are very business-friendly and investors are most familiar with them.

How to incorporate your company

Incorporating as an LLC

To organize your company as an LLC, create a business name that includes LLC at the end. You may need to appoint a registered agent if your President or CEO is not located in the state you are incorporating in. You will then want to file your LLC’s articles of association with the state corporation commission, state secretary, or other appropriate office in your state of choice. No matter which state you choose, you will need to register for an Employer Identification Number, also called a TIN, with the IRS for filing taxes. You can apply for an EIN online through the IRS website.

Incorporating as an S-corp or C-corp

To incorporate as an S-corp or C-corp, in addition to registering the company name, address, owners and officers at the state level, you must file the correct tax forms with the IRS. If your company meets the S-corp requirements of issuing only common stock to fewer than 100 shareholders who are not themselves corporations and all of whom are US-based, then you can file form 2553, which is due to the IRS no later than 2 months and 15 days after the start of the tax year. Obviously any change of corporate form, such as conversion from an LLC to an S-corp, requires you to notify the existing members/partners/stockholders of the change.

If you are transitioning from an S-corp to a C-corp, you must petition the IRS to revoke your company’s former S-corp status. If your company meets all requirements of a C-corp, then you can file IRS form 1120 to request that status.

Why incorporate in Delaware?

When you incorporate an S-corp or C-corp, Delaware is known for its predictable, business-friendly legal system and lack of corporate taxes. Delaware offers investor-friendly laws, no state income tax, and strong IP protection, making it the top choice for 68% of Fortune 500 companies.

Wyoming, Nevada, Texas, Florida, and South Dakota have also increased their popularity as incorporation venues with no corporate or state income taxes, or both.

While there may be apparent tax breaks and attractive legal systems far from home, there can also be added costs to incorporating outside of the state you live or primarily do business in.

When creating complex corporate structures, it’s advisable to keep as much of that structure simple and consistent as possible. If a Delaware company has a New Jersey subsidiary, you may want that subsidiary to be wholly 100% owned by the top company to ensure that all investors invest only in the top company and not in any subsidiaries.

As you look to launch your startup, whether you’re incorporating as an LLC, S-corp or C-corp, SeedLegals is here to help. Our simple to use end-to-end platform takes care of the legal processes traditional law firms typically handle – saving you time and money.