Despite what you may read in certain corners of the web, a C corporation is not necessarily the best entity choice for every startup, even if the startup is seeking venture capital funding. Entity selection is one place where good legal counsel and a knowledgeable accountant can really pay off for a startup. The same factors that will help influence the funding source you choose for your startup will also drive the entity choice for your startup. We summarize funding sources in this post. The following factors will influence what the best entity type is for your startup: your personal financial situation, the industry you are planning on operating within, your growth projections, the funding source you decide to pursue, and your exit strategy.
Typically, a startup will elect to be either a corporation or a limited liability company. Both entity types are popular because they offer limited liability protection to the owners of the equity of those entities. This means that, in most cases, an equity owner’s liability will be capped at the amount of money they have invested in the limited liability company or corporation.
The term used to refer to the owners of the equity of a legal entity depends on the type of entity. If the legal entity is a limited liability company, then the equity owners are referred to as members. If the legal entity is a corporation, then the equity owners are referred to as shareholders or stockholders, depending on the jurisdiction in which the corporation was formed (most jurisdictions, including Vermont, use the term “shareholders,” while Delaware uses the term “stockholders”). In this post, we use the term “equity owner” to refer to both members and shareholders/stockholders when collectively referring to limited liability companies and corporations.
We summarize below the key distinctions between limited liability companies and corporations.
Limited Liability Company
Formation
A limited liability company is formed by filing articles of organization with the Secretary of State of the state in which you wish to form your limited liability company. The articles of organization are referred to as the “certificate of formation” in some jurisdictions, such as Delaware. When forming a limited liability company, you will need to choose a registered agent for your limited liability company. Typically, if you are forming the limited liability company in the state in which your startup will operate, you can appoint yourself as the registered agent. If you are forming a Delaware limited liability company, and you are not located in Delaware, then you will need to appoint a professional registered agent that has a physical location in Delaware.
Governance
Of all the entity types, limited liability companies provide the greatest flexibility regarding governance. You can make the governance structure of a limited liability company as rigid as a corporation or as loose as a sole proprietorship all depending on what best suites your specific circumstances. The governance structure you choose will largely depend on the number of equity owners of the limited liability company. The equity owners of limited liability companies are referred to as “members.” If there is just one member of the limited liability company, then the governance structure will essentially be non-existent, other than some protective provisions to ensure that the limited liability company is recognized as a legal entity separate from its sole member. If there are multiple members, then the governance structure will likely begin to look more like the governance structure of a corporation (i.e., regular meetings, procedures for those meetings, a board of managers, etc.).
The rights, privileges, and obligations of the members are set forth in a document typically referred to as an “operating agreement.” Some jurisdictions such as Delaware refer to the operating agreement as a “limited liability company agreement.” The operating agreement sets forth each member’s rights, privileges, and obligations vis-à-vis the other members of the limited liability company and the limited liability company itself.
Limited liability companies can either be member-managed or manager-managed. In a member-managed limited liability company, the members collectively make decisions impacting the limited liability company’s business and decisions affecting the internal affairs of the limited liability company. In a manager-managed limited liability company, the managers make decisions impacting the limited liability company’s business and, to varying degrees depending on what is set out in the operating agreement for the limited liability company, decisions affecting the internal affairs of the limited liability company. Managers of a limited liability company do not need to be members.
Administrative Costs
The number of members of a limited liability company will be a big driver in determining the administrative costs of upkeeping the limited liability company. A single-member limited liability company has very low administrative costs, while a multi-member limited liability company with a complicated capital structure (e.g., multiple classes of equity, etc.) will likely have a higher administrative cost than a corporation with a similar capital structure. The increased administrative cost is largely because multi-member limited liability companies are typically taxed as partnerships, and the administrative costs (accounting and legal fees) needed to correctly maintain a limited liability company taxed as a partnership are greater than similar costs for a corporation.
Tax Considerations
Limited liability companies with one member are treated as disregarded entities for tax purposes. This means the limited liability company is no different than the sole member for tax purposes. Essentially, a single member limited liability company is the same as a sole proprietorship for tax purposes. The benefit of forming a limited liability company instead of just operating a sole proprietorship is that the member of a single-member limited liability company has the benefit of limited liability protection. Within certain limits, which are beyond the scope of this post, a multi-member limited liability company can elect to be taxed as either a partnership, an S corporation, or a C corporation. Unless the members of a multi-member limited liability company affirmatively elect for the limited liability company to be taxed as an S corporation or a C corporation, the limited liability company will be taxed as a partnership.
Income and losses of a limited liability company that elects to be taxed as a partnership is passed through to its members. In other words, the income and losses of the limited liability company are treated as income and losses of the limited liability company’s members, typically in proportion to each member’s equity interest in the limited liability company. There is no separate tax at the entity level for limited liability companies that elect to be taxed as a partnership under federal law. Traditionally, passthrough entities such as limited liability companies taxed as partnerships also were not subject to an entity level tax under most state’s laws. This has changed in recent years in response to the Tax Cuts and Jobs Act of 2017, which limited the amount of deductions equity holders of passthrough entities can claim for state and local taxes. This trend may change again depending on whether the limitation on deductions for state and local taxes sunsets following the 2025 tax year.
Limited liability companies need to issue their members annual tax forms (IRS Form K-1), which let each member know their share of any income or losses of the limited liability company that is being passed onto such member as a result of such member owning equity in the limited liability company. To ensure compliance with the complicated partnership tax laws and the annual reporting requirements of limited liability companies taxed as a partnership, it is critical that limited liability companies work consistently with a knowledgeable accountant or tax lawyer who is familiar with partnership tax law.
Employees and Employee-Equity
A member of a single-member limited liability company and members of limited liability companies taxed as partnerships cannot be W-2 employees of the limited liability company. Instead, such members are treated for tax purposes as being self-employed, which means such members’ will be subject to self-employment taxes. This tax treatment often encourages limited liability companies to elect to be taxed as an S corporation. Equity owners of an S corporation can be W-2 employees.
While there are many ways to grant employees equity in a limited liability company, there are factors that make it more difficult and costly than it is to issue equity to an employee of a corporation. As noted above, if a W-2 employee of a limited liability company taxed as a partnership becomes an equity owner of the limited liability company after receiving an equity incentive grant from the limited liability company, then such employee will no longer be able to be a W-2 employee. Limited liability companies taxed as a partnership may be able to avoid this outcome by forming a management holding company through which employees of the limited liability company can indirectly own their interest in the limited liability company. While this may be doable, there is some tax exposure in that the Internal Revenue Service could set aside the management holding company and still find that the employee is a member of the limited liability company. Additionally, setting up and administering this structure is expensive and complicated to maintain over time.
Another reason equity incentives are more difficult to grant and administer through a limited liability company compared to a corporation is that it may be difficult to pin down the economic value of an equity incentive issued by a limited liability company at any one time because the limited liability company could have a complicated distribution waterfall that includes multiple preferences and hurdles, depending on the capital structure of the limited liability company. This could make the equity incentive less of an incentive for employees if they do not immediately see the value of the equity incentive that they receive from the limited liability company.
The two most common forms of equity incentives granted by limited liability companies taxed as partnerships are options and profits interests. Options granted by a limited liability company are substantially similar to options granted by a corporation, however, when exercised, the person exercising the option becomes a member of the limited liability company, which has the consequences noted above if such person is an employee of the limited liability company. We’ll discuss options more below in the context of corporations.
Profits interests are a concept that is unique to limited liability companies and other entities taxed as partnerships. When a person becomes a member of a limited liability company, they typically receive a capital interest in the limited liability company. A capital interest entitles the holder of the interest to the built-in value of the limited liability company at the time the holder receives the capital interest plus any appreciation in value of the limited liability company after the date the holder receives the capital interest. A profits interest by contrast only entitles the holder of the interest to the appreciation in value of the limited liability company after the date the holder receives the profits interest. The benefit of profits interests is that the recipient of a profits interest will typically not be deemed to have received taxable income as a result of receiving the profits interest as long as the limited liability company correctly structures the profits interest and, if the profits interest is subject to vesting, the recipient of the profits interest files an 83(b) election. We’ll discuss 83(b) elections in a separate post.
Corporation
Formation
A corporation is formed by filing articles of incorporation with the Secretary of State of the state in which you wish to form your corporation. The articles of incorporation are referred to as the “certificate of incorporation” in some jurisdictions, such as Delaware. When forming a corporation, you will need to choose a registered agent for your corporation. Typically, if you are forming the corporation in the state in which your startup will operate, you can appoint yourself as the registered agent. If you are forming a Delaware corporation, and you are not located in Delaware, then you will need to appoint a professional registered agent that has a physical location in Delaware.
Governance
Unlike a limited liability company, most corporation statutes require that corporations comply with statutorily defined governance structures. Most corporations (other than corporations that have elected to be a close corporation, which are outside the scope of this post) need and are managed by a board of directors. The equity owners of a corporation, which are referred to as “shareholders” or “stockholders,” depending on the jurisdiction of the corporation, typically set the size of the board of directors. There must be at least one director. Shareholders also typically elect the members of the board of directors. Other than electing the board of directors, the shareholders are not typically involved in the day-to-day operation of the corporation in their capacity as shareholders. A shareholder can be an employee and/or director of the corporation.
Most of the time, shareholders are required to have an annual meeting during which they elect the corporation’s board of directors. The procedures for conducting the annual meeting and any special meetings of the shareholders held during the year are set forth in the corporation’s bylaws. Similarly, the board of directors is typically expected to meet regularly and the procedures for the board of directors’ meetings are set forth in the bylaws.
When a corporation starts taking on third party investments, the investors will often negotiate certain protective provisions, which are set forth in the articles of incorporation or certificate of incorporation, depending on the jurisdiction. These protective provisions give investors certain consent rights over enumerated actions of the corporation. The types of corporate actions covered by the protective provisions typically include the sale of the business, issuing additional equity interests in the corporation, and other things of that nature.
Administrative Costs
The annual filing fees of a corporation are typically higher than the annual filing fees for a limited liability company. Other than that, however, the ongoing administrative costs of a corporation are often similar to or less than the administrative costs of a multi-member limited liability company with a similar capital structure. This is mainly because corporations do not need to comply with the complicated partnership tax laws noted above, which most limited liability companies need to comply with, and most multi-member limited liability companies end up adopting a governance structure similar to a corporation.
Tax Considerations
Unlike limited liability companies, corporations are subject to a separate tax at the entity level (i.e., a corporation is taxed separately from its shareholders). Shareholders are then taxed separately on any distributions they receive from the corporation. This often is referred to as double taxation. Despite double taxation, corporations have become an attractive entity form from a tax perspective in recent years because of changes to the Internal Revenue Code made as a result of the Tax Cuts and Jobs Act of 2017 and the potential tax savings afforded by Section 1202 of the Internal Revenue Code.
The Tax Cuts and Jobs Act lowered the federal income tax rate for corporations to a flat rate of 21%. This is very favorable compared to the individual federal income tax rates, which in 2024 go up to 37% for individuals with the highest incomes. To the extent a startup can keep profits in the business (i.e., not make distributions to shareholders), then corporations may be more tax advantageous than limited liability companies as long as the corporate tax rate remains so much lower than the individual tax rates. Another benefit of corporations from a tax perspective is that they can deduct state and local taxes (SALT) without limitation. Following the Tax Cuts and Jobs Act, individuals are limited to a $10,000 SALT deduction. This limit is set to sunset following the 2025 tax year.
Section 1202 of the Internal Revenue Code has been around for years, but prior to the reduction of the corporate tax rate it was underutilized. Section 1202 provides that a shareholder may exclude 100% of the proceeds they receive from selling stock of certain qualified small businesses if the shareholder holds the stock for at least five years. Section 1202 only applies to C corporations engaged in certain types of business that have less than $50 million in assets at the time the stock is purchased. There are many limitations on utilizing Section 1202, and it is highly recommended that you work closely with tax counsel prior to making any representations regarding whether the shares issued by your corporation may qualify for Section 1202 treatment and before any shareholders make any transfers of qualifying 1202 stock. Failure to strictly comply with the transfer and redemption rules of qualifying 1202 stock can cause loss of Section 1202 treatment to either the shares transferred or redeemed or all stock of the corporation depending on the facts and circumstances.
Employees and Employee-Equity
Another benefit of utilizing a corporation is that it is often more advantageous for shareholders to be employees of a corporation than it is for a member of a limited liability company to be an employee of the limited liability company. Additionally, it is easier and more cost effective to create an employee equity incentive plan for a corporation than it is for a limited liability company. The two most common types of equity incentives granted to employees of a corporation are options and restricted stock.
An option entitles the recipient of the option a right to purchase a predetermined number of shares of a corporation’s common stock at a predetermined price. The predetermined price is referred to as the “strike price” or “exercise price.” Typically, an option is subject to vesting, which means that the option holder cannot exercise the option to purchase the shares covered by the option until a certain period of time has passed (this is referred to as “time-based vesting”) or certain milestones have been achieved (this is referred to as “milestone-based vesting”). Once shares of stock subject to an option have vested, then the option holder may exercise the option with respect to such vested shares by paying the corporation the strike price. An option holder does not become an owner of the shares subject to the option until they have exercised the option and paid the strike price to the corporation.
Restricted stock is a term used to refer to shares of common stock that are subject to a repurchase option benefitting the corporation. This repurchase option typically lapses over time as the shares vest with the recipient of the restricted stock. As with options, restricted stock can either be subject to time-based vesting or milestone-based vesting. Even though the shares of restricted stock are initially subject to vesting, the recipients of restricted stock immediately become the record owner of the shares of common stock they receive. Such recipients can either purchase the restricted stock or receive the restricted stock as consideration for services rendered. If a recipient receives restricted stock in exchange for services rendered, then the recipient will be deemed to have received income equal to the fair market value of the shares of restricted stock. Unless the recipient files an 83(b) election, the recipient will be deemed to take such shares of restricted stock as income as the shares of restricted stock vest with the recipient. We’ll discuss the importance of filing an 83(b) election in a separate post.
Jurisdiction of Formation
In addition to choosing the right entity type for your startup, you also want to carefully consider the jurisdiction in which you form the entity through which you will start and grow your business. If you know you will likely need to seek third-party investments to help fund your startup, then it may make sense to form an entity under Delaware law. Investors typically prefer investing in entities that were formed in Delaware for three reasons. First, Delaware’s statutes governing limited liability companies and corporations are cutting edge because they are frequently updated to align with technological innovations and business trends. Second, Delaware has a court dedicated to resolving business disputes, the Court of Chancery, which is comprised of judges that are familiar with the complicated issues that are typically at the center of most business disputes. Third, Delaware case law typically tracks business expectations and is fairly well settled compared to other jurisdictions. These things are important to investors because they help reduce two areas of risk: first, they provide a clear framework for how the internal affairs of a business entity should be handled; and second, they provide greater certainty with respect to how business disputes will be resolved.
The downside to forming an entity in Delaware is that it is typically more expensive than forming an entity in another jurisdiction. This is especially true for corporations. Additionally, it is not just the cost of formation that is more expensive. The ongoing costs are more expensive in Delaware as well. This is because the annual filing fees are more expensive in Delaware and most entities need to hire and maintain a professional registered agent in Delaware for their business entity.
Where you ultimately decide to form the entity for your startup will depend on your specific facts and circumstances. Competent legal counsel can help advise you on which jurisdiction is best for your particular situation and help you weigh the pros and cons of forming your entity in different jurisdictions.
Conversions
It often makes sense for a startup to initially form as a limited liability company and then later convert to a corporation when the startup is ready to start taking on third-party investments. Doing this allows early equity owners, such as founders, to take advantage of losses generated by the startup. If you are unable to utilize the losses generated by the startup because you do not have income from another source, then you likely will want to form a corporation from the beginning so that you can start the clock on the 1202 treatment of the shares you hold from the corporation as soon as possible.
Conclusion
As with any decision regarding your startup, what is right for you will depend on your specific facts and circumstances. We are happy to help advise you on the optimal entity form for your startup. Please contact us if you would like to set up a consultation.
