Which Legal Form For Your Business?

In a previous article, we discussed legal basics. We recommended incorporating as a Delaware C-Corp, and said that this is the only form that Clerky supports. We’re going to take a deeper look at this issue here.

The possible legal forms that you can choose from are a S-Corp, a C-Corp, a partnership, a sole-proprietorship, and a limited liability corporation (LLC).

S-Corp An S-Corporation allows stock to be issued to shareholders. But there are some restrictions: Shareholders must be U.S. entities, there can only be one class of stock, and there can be a maximum of 100 shareholders. There are some benefits to choosing this corporate form. The S-Corp is a pass-through entity. Profits from the Corporation are passed through to shareholders at the end of the year. So the corporation escapes income tax. But most significantly, distributions in excess of shareholder contributions are treated as capital-gains distributions.

In an S-Corp with one shareholder, as long as a reasonable wage is paid to the employees, a significant amount of the profits of the corporation can be distributed as capital gains, which have a much lower tax rate than income. A rule of thumb is that you can distribute 60% as wages, and 40% as capital gains, saving a huge amount of payroll tax. The S-Corp is a very popular way to get taxed because of the tax savings. The Tax Advisor is a tremendous reference on the subject.

C-Corp This is the orignal corporate form. In contrast to the S-Corp, you can have multiple classes of stock. Venture Capitalists will insist on this. They will want preferred stock, which only a C-Corp can issue. This is why the standard advice is to incorporate as a C-Corp. C-Corps are also not restricted from having international investors. It is the most flexible legal form.

The downside of a C-Corp is that distributions to shareholders are taxed twice: once at the corporate level, and again as income to the shareholder. Some people say that it is more difficult to administer a C-Corp, but I have not found it onerous. It may in fact be easier. If you want to raise money, Y-Combinator has a nice set of investment documents ready for use, but they are only usable by C-Corps. This is because of the flexibility of the C-Corp and the demand by VCs for preferred stock.

Partnership S-Corps and C-Corps are legally separate entities from the owners. This is important. If the corporation is sued or goes bankrupt, owners are insulated from liability. If this were not the case, few would take the risk of starting businesses. A partnership is not legally separate from the owners. It is an entity owned by the partners where the profits and liabilities of the business are shared among the owners. Income flows directly to the owners, who include the income on their tax returns. However, due to the personal liability that a partnership incurs, this is not a recommended corporate form.

Sole Proprietorship Until recently, this was the most popular corporate form. This is a partnership where there is only one partner. The tax identification number of the company is the same as the owner. The IRS considers this to be a disregarded entity, basically the same as the owner. Setting up this type of business is extremely easy, which is why it has been so popular. However, it is always better to limit personal liability by choosing another corporate form, which we now discuss.

Limited Liability Corporation (LLC) The LLC is the newest corporate form. As its name implies, it insulates the owners from personal liability for acts the corporation takes. So it is always a better choice than a partnership or a Sole Proprietorship. Owners are called Members. If an LLC has one member, states and the IRS will treat the LLC as a Sole Proprietorship for tax purposes. If the LLC has multiple members, it will be treated like a partnership. Because of the relatively low administrative burden of setting up an LLC and the limited liability nature, the single-member LLC is now the most popular corporate form.

Interestingly, LLCs can file a form with the IRS and ask to be treated as an S-Corp or a C-Corp for tax purposes. This allows the LLC to reap the significant tax benefits of an S Corp, while perhaps having a lower administrative burden with the Secretary of State. In this case, the Secretary of State will consider the corporation to be an LLC, while the IRS will consider the LLC to be an S-Corp or a C-Corp. Anderson CFO is an LLC that has opted to be treated by the IRS as an S-Corp.

LLCs cannot issue stock. Members own membership interests that usually are proportional to contributed capital, but not always.

Conclusion If you plan to take Venture Capital, incorporate as a C-Corp. Clerky will do this for you very cheaply, and you can use the SAFE documents that Y-Combinator provides for free. These SAFE documents cannot be used by other corporate forms. LLCs can engage in SAFEs, but they would need a lawyer’s advice to set up.

If you are never going to take in investor capital, you will most likely want to choose the LLC form with S-Corp taxation. This will allow owners to invest in the company and maintain different ownership interests, although in a less formal way than with the S-Corp or C-Corp legal forms.