Entity Formation: Starting Points for Tech Startups

By: Eitan Davis

A few months ago, you woke up with an idea for a product or service that would fill a gap in the market. You googled sporadically for days only to find that, interestingly enough, no one seemed to have arrived upon the same idea. And so, you set off to build it out. Countless hours behind your respective building table later, you’re finally sitting behind a minimum viable product, casually pitching its utility to anyone who will listen. The response is positive and you’re starting to gain some traction. “This might actually take off,” you muse. As your 4th cup of coffee reaches room temperature, you realize it’s time to form an entity. At this point, you’re familiar with the names and basic functions of the various business types, but where can you find the benefit in forming an LLC over a C-Corporation, or vice versa? Are there any drawbacks? Will your choice prevent you from actualizing some future ambition? Which is right for you?

This is a necessary crossroad for every startup. The implications can be substantial, since the entity type the business takes on can greatly affect the future growth and viability of the company as a whole. Though a little daunting at first, the proper path tends to become clearer when some important preliminary questions are answered.

The Two Basic Types of Business Entities

Each entity is similar in that it serves to limit the liability of its owners in various degrees. However, they differ largely in their corresponding tax treatment.

LLC

An LLC is a “pass through” entity taxed as a partnership. Each owner (“member”) pays tax on the income they receive through the LLC in accordance to their share of profits or losses, the proportions of which are determined by the LLC agreement. In the case that there is a sole member, the LLC would be treated as a “disregarded entity” and the LLC’s total losses and profits would be included on the sole member’s personal tax return. Like a corporation, the LLC can be created with provisions allocating different classes of ownership with customizable rights. Since relatively few formalities are required for its annual maintenance, LLCs are also generally easier to set up and maintain than C-Corps.

C-Corporation

Unlike an LLC, a C-Corporation is a distinct entity for tax purposes, subject to federal income tax that is paid through the entity on its income. Unless the corporation pays dividends to its stockholder, the stockholder will not incur tax liability on the earnings of the corporation. There are numerous other tax implications that may prove advantageous down the line.

Whereas ownership of an LLC can be divided among its members in the proportions allocated in (or later amended to) the operating agreement, ownership of a corporation is issued in the form of shares of the company, to any number of stockholders. However, the number of shares issued does not necessarily represent a fixed percentage of ownership that is guaranteed to last throughout the lifetime of the corporation. For example, say your corporation authorizes 100 shares at formation. Soon after, it issues 25 shares to each you and your partner, for a total of 50 shares issued, making you 50-50 owners. Later on, in a subsequent round of funding, you issue the remaining 50 authorized shares to an angel investor while retaining your 25 each. The change in the total issued shares from 50 to 100 is immediately reflected in your ownership of the corporation, taking you from a 50% owner down to a 25% owner. Dilution of a corporation showcases the conventional importance of keeping as much of your equity as you can while fundraising.

Why most startups should (and most often do) opt to form a C-Corp

Investors

Perhaps the most important and least technical reason for forming a C-Corp rather than an LLC is simply that investors prefer and expect it. Taking on membership in an LLC would complicate an investor’s personal tax liability, where they would be taxed on the company’s earnings even when those earnings are being reinvested into the company, regardless of whether or not any cash has been distributed. Indeed, some venture capital firms are prohibited entirely from investing in pass-through entities like LLCs because they are comprised of tax-exempt partners whose positions could be compromised by active business income. With a C-Corp, an early stage investor simply acquires a capital asset (stock) and only deals with tax implications upon its sale, where the capital gain or loss event occurs.

Special Tax Treatment

The Section 1202 reduction in capital gains tax for qualified small businesses (“QSBS”) allows “an individual taxpayer (to) exclude 50% (and sometimes more) of the gain realized on the sale of a QSBS stock if the taxpayer holds the stock for more than 5 years prior to sale. The taxpayer can also defer recognition of gains if the taxpayer reinvests in QSBS within specified time parameters.” This yields a potentially huge advantage to investors in it for the long haul and is unavailable for investments in LLCs.

Liability

For investors and founders alike, there is well-developed corporate case law – largely stemming from the Delaware courts - in whose jurisdiction most American corporations are formed. Precedent predominantly favors business and provides many safeguards protecting officers and board members from being held liable for the business’s actions. While this body of law does extend to LLCs, the extent of that reach is in many ways still unclear. The overwhelming focus has been and continues to be the C-corporation.

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When it comes down to it, for startups – particularly in tech – whose objectives involve rapid growth, equity grants, multiple rounds of fundraising, reinvestment of capital and, ultimately, an initial public offering, the C-Corp presents structural advantages that make it the clear choice for many founders.