Why are startups C-Corp? What type of entity should I be?
The Why
I was recently giving a talk, and someone asked the question: which type of entity should I be for a startup?
Disclaimer: I am not a lawyer; this is not legal advice. Just informational to help you understand the landscape — consult your attorney or accountant.
The short answer is C-Corp, but let’s walk through it. I’ll go through the most common entity types, Sole Prop, S-Corp, LLC, and C-Corp. You’ll find a breakdown of each entity type below to give you an in-depth explanation of each.
First, don’t ever, under any circumstance, be a sole-prop. You leave yourself open to all liabilities, which means that anyone that sues you can come after your personal assets. They could get your house, your car, literally everything. Do. Not. Do. It.
S-Corps are great for taxes, and when people incorporate outside of the startup world, they generally will go this route or an LLC. It avoids double taxation, and you have more flexibility in what you can write-off VS a sole-prop. It also gives you a corporate veil of protection. Startups that are self-funding a decent amount of their initial costs could consider becoming an S-corp before transitioning to a C-Corp because as an S-Corp you can take the losses that the corporation will inevitably have.
LLC: If you started the process of moving away from a sole prop and stopped at your lawyer’s first, you’ll become an LLC. If you stopped at your accountant’s first, you’d become an S-corp.
C-Corp: Why are most startups C-corps? Well, because they offer the flexibility to do everything you need to do (adding investors, giving equity outside of the US, etc.), double taxation won’t apply to you, and you could qualify for Qualified Business Business Stock.
The biggest downside of a C-Corp is double taxation:
When a C-corporation generates income, it is required to file its tax return with the Internal Revenue Service (IRS). After deducting business expenses and salaries, the remaining income is subject to tax. This net income is also distributed to shareholders in the form of dividends. These dividends are income to the shareholder and are reported on the individual’s tax return. Therefore, profits from a C corporation are taxed at the corporation’s tax rate and individual’s tax rate.
But guess what? Startups never distribute dividends as income is reinvested into the venture, so the biggest downside of a C-Corp is gone!
Qualified Small Business Stock
Gains from selling Qualified Small Business Stock (QSBS) may be eligible for up to 100% exclusion from federal income tax — which means, when you sell your qualifying stocks, you could avoid paying federal tax on gains of up to $10 million or 10x your tax basis. For example, if you invested $2 million in a QSBS in 2013, you could sell that stock five or more years later for up to $22 million and pay zero federal income tax on that gain, a savings of nearly $5 million at today’s rates.
How to qualify?
• Company is a domestic C corporation
• Stock is issued after August 10, 1993
• Stock is acquired by taxpayer directly from the company for money, property (other than stock), or services (limited exceptions to this rule)
• The tax basis of the total gross assets of the corporation at all times from August 10, 1993, until immediately after the issuance of the taxpayer’s stock must be less than $50 million
(Thanks Investopedia for the material)
Types of entities
Sole Proprietorship (Sole Prop)
General Partnership (GP)
Limited Partnership (LP)
Limited Liability Company (LLC)
Subchapter S Corporation (S-Corp)
C-Corporation (C-Corp)
Limited Liability Partnership (LLP)
Sole Proprietorship
A sole proprietorship, also known as a sole trader or a proprietorship, is an unincorporated business with a single owner who pays personal income tax on profits earned from the company. With little government regulation, a sole proprietorship is the most straightforward business to set up or take apart, making sole proprietorships popular among individual self-contractors, consultants or small business owners.
Breaking it down:
A sole proprietorship has no separation between the business entity and its owner. It is therefore different from corporations and limited partnerships, in that no separate legal entity is created. Consequently, the business owner of a sole proprietorship is not safe from liabilities incurred by the entity. For example, the debts of the sole proprietorship are also the debts of the owner. However, all profits flow directly to the owner of a sole proprietorship.
The benefit of the sole proprietorship is the pass-through tax advantage, mentioned above. The disadvantage of a sole proprietorship is obtaining capital funding, specifically through established channels, such as issuing equity and obtaining bank loans or lines of credit. As a business grows, it often transitions to a limited liability company (LLC) or an S-corporation.
General partnership
A joint business where the profit & liability (or debt) is shared by the general partners.
Breaking it Down
Nothing to file with state fed etc.
Written partnership agreement between the parties and will be reflected individually on the partner’s tax returns
Since all partners have unlimited liability, even innocent partners can be held responsible when another partner commits inappropriate or illegal actions. This fact alone demonstrates how an investor should heed caution when deciding on whether to become a general partner.
Note: As a caution being a Sole Proprietor or part of a general partnership can be dangerous from a liability standpoint. If anything goes wrong from a legal standpoint, your personal assets are at risk.
If you are starting a business, do not use either of these methods as they leave you open to losing everything.
Limited Partnership — LP
A limited partnership (LP) exists when two or more partners unite to jointly conduct a business in which one or more of the partners is liable only to the extent of the amount of money that partner has invested. Limited partners do not receive dividends, but enjoy direct access to the flow of income and expenses. The main advantage of this structure is that the owners are typically not liable for the debts of the company.
Breaking it Down
A partnership is a business that is owned by two or more individuals. There are three forms of partnerships: general partnership, joint venture, and limited partnership. The three forms differ in various aspects, but they share similar features.
LLC (Limited Liability Company)
A limited liability company (LLC) is a corporate structure whereby the members of the company cannot be held personally liable for the company’s debts or liabilities. Limited liability companies are essentially hybrid entities that combine the characteristics of a corporation and a partnership or sole proprietorship. While the limited liability feature is similar to that of a corporation, the availability of flow-through taxation to the members of an LLC is a feature of partnerships.
Protections of a Corporation
The primary reason an LLC is selected as an ownership structure is to limit the principals’ personal liability. An LLC is often thought of as a blend of a partnership, which is a simple business formation of two or more owners under an agreement, and a corporation which is afforded certain liability protections.
Flexibility of a Partnership
The primary difference between a partnership and an LLC is that an LLC is designed to separate the business assets of the company from the personal assets of the owner, which has the effect of insulating the owners from the LLC’s debts and liabilities. An LLC functions similar to a partnership in that the profits of the company pass through to owners’ tax return.
Regarding the sale or transfer of the business, a business continuation agreement is the only way to ensure the smooth transfer of interests when one of the owners leaves or dies. Absent a business continuation agreement, an LLC must be dissolved in the event of a bankruptcy or the death of a partner.
S-Corporation (S-corp)
A Subchapter S (S Corporation) is a form of corporation that meets specific Internal Revenue Code requirements, giving a corporation with 100 shareholders or less the benefit of incorporation while being taxed as a partnership.
The corporation can pass income directly to shareholders and avoid the double taxation that is inherent with the dividends of public companies, while still enjoying the advantages of the corporate structure. Requirements include being a domestic corporation, not having more than 100 shareholders, including only eligible shareholders and having only one class of stock.
Breaking it Down
Corporations filed under Subchapter S may pass business income, losses, deductions and credits to shareholders. Shareholders report such income and losses on their personal tax returns and pay tax at individual income tax rates. S corporations pay tax on specific built-in gains and passive income at the corporate level.
An S corporation must be a domestic company with individuals, specific trusts, and estates as shareholders. Partnerships, corporations and non-resident aliens do not qualify as shareholders.
Advantages of Filing Under Subchapter S
Shareholders may be employees of the company, draw employee salaries and receive corporate dividends or other distributions that are tax-free in relation to each shareholder’s investment in the business. Characterizing distributions as salary or dividends may help the owner reduce liability for self-employment tax while generating business-expense and wages-paid deductions. Also, the S corporation does not pay federal taxes at the entity’s level; the losses may offset other income on the shareholders’ tax returns.
Disadvantages of Filing Under Subchapter S
The Internal Revenue Service (IRS) scrutinizes payments distributed to shareholders as salary or dividends as a way of ensuring characterization is realistic. Therefore, if wages are characterized as dividends, the business loses a deduction for compensation paid. Similarly, if dividends are characterized as wages, the business pays more in employment taxes.
C-Corporation (C-Corp)
Any corporation that is taxed separately from its owners.
C corporations are an alternative to S corporations, where profits pass through to owners and are only taxed at the individual level, and limited liability companies, which provide the legal protections of corporations but are taxed like sole proprietorships.
Breaking it Down
While the double taxation of C corporations is a drawback, the ability to reinvest profits in the company at a lower corporate tax rate is an advantage. Most corporations are C corporations.
Organizing a C Corporation
Once the corporation’s name has been chosen, some states require it to be reserved with the secretary of state. The articles of incorporation must be drafted and filed with the state. Stock certificates can be issued to the initial shareholders upon creation of the business. All C corporations must file Form SS-4 to obtain an employer identification number (EIN). Although requirements vary across different jurisdictions, C corporations are required to file state, income, payroll, unemployment and disability taxes.
Maintenance of C Corporation
A C corporation is required to hold at least one meeting each year for shareholders and directors. Minutes must be maintained to display transparency in how the business operates. A C corporation must maintain the voting records for the company’s directors and a list of owner’s names and ownership percentages. The business must maintain the company bylaws on the premises of the primary business location. These organizations file annual reports, financial disclosure reports, and financial statements.
Benefits of a C Corporation
C corporations limit the personal liability of directors, shareholders, employees, and officers. Legal obligations of the business cannot become personal debt obligations of any individual associated with the business.
Double Taxation
The major downside of C corporations relates to the double taxation that occurs. When a C corporation generates income, it is required to file its tax return with the Internal Revenue Service (IRS). After deducting business expenses and salaries, the remaining income is subject to tax. This net income is also distributed to shareholders in the form of dividends. These dividends are income to the shareholder and are reported on the individual’s tax return. Therefore, profits from a C corporation are taxed at the corporation’s tax rate and individual’s tax rate. Only net income retained by the C corporation temporarily avoids double taxation.
Limited Liability Partnership
A limited liability partnership (LLP) is a partnership in which some or all partners (depending on the jurisdiction) have limited liabilities. It, therefore, exhibits elements of partnerships and corporations.
Breaking it Down
In an LLP, each partner is not responsible or liable for another partner’s misconduct or negligence. This is an important difference from the traditional unlimited partnership under the Partnership Act 1890 (for the UK), in which each partner has joint liability. Unlike corporate shareholders, the partners have the right to manage the business directly. In contrast, corporate shareholders have to elect a board of directors under the laws of various state charters. The board organizes itself (also under the laws of the various state charters) and hires corporate officers who then have as “corporate” individuals the legal responsibility to manage the corporation in the corporation’s best interest. A LLP also contains a different level of tax liability from that of a corporation.
Lucas is the founder of Spark xyz, platform management software for incubators, accelerators, Angel groups, and VC’s.
