In the (popular) Dungeons & Dragons paper and dice role-playing game, players choose which race their character will be. They can choose between Human, Dwarf, Orc, Elf, and Halfling. Founders get to do the same when founding a business, but they get to choose which entity-type their business will be. They get to choose from a long, and growing, list of entity types including corporation, limited-liability company, limited-partnership, and non-profit.
The entity-type of a business determines some key structural characteristics that can have a huge impact on how founders, employees, and stakeholders behave. It’s an important decision to get right.
In this guide, we’ll take a look at some of the key entity options, focusing primarily on C-corporations and LLCs, because that is what most of our clients ask about.
(The short answer: If you want to raise venture capital money, form as a C-corp.)
Corporations
Corporations are legal entities owned by shareholders. Most well-known businesses are corporations, like Microsoft Corp. Here are some key points about corporations that we’ll look at more closely. Corporations
- Protect shareholders from liability
- Have a complex structure of shareholders, directors, and officers that is preferred by venture capitalists
- Are taxed twice.
Shareholders are protected from liability.
That means shareholders, or owners, can’t be sued for the debts of or damages caused by the corporation. However, a founder is usually both a director and a shareholder. Directors are also protected from lawsuits by the business judgment rule. The business judgment rule provides that a director can’t be sued simply for making a bad decision and protects them so long as they weren’t doing anything sketchy. That said, in some situations, the “corporate veil” can still be pierced and the owner sued, if the owner treats the company as an extension of his personal self.
Corporations have a complex structure
Corporations include three main parties: shareholders, directors, and officers. Founders are usually all three. Officers include people who act on behalf of the company, mainly the C-suite. Shareholders are those who own any part of the company. Directors are elected by shareholders. Investors often require a position on the board of directors. The shareholders own the company and elect directors who establish corporate policy and appoint officers. The officers, in turn, manage and operate the business. This corporate structure is one of the main reasons venture capitalists prefer corporations: they allow for the easy division of ownership and duties and provide a standardized and familiar governance.
Corporations are taxed twice.
This is called double taxation. A company’s income is taxed at the corporate rate. Then that money is taxed again when it is paid out in dividends to the company’s shareholders. This used to be a larger problem than it is currently. The Tax Cuts and Jobs Act of 2017 dropped the tax rate for C corporations to a flat 21 percent. This lowered the tax rate of corporations significantly. This change made corporations more competitive with LLCs in regards to tax rates again. Besides, double taxation isn’t really a big deal for startups anyways because entity tax is so low.
Also in regards to tax, as of 2015, corporations allow for an exit free from federal income tax for qualified small business stock (QSBS) under 26 US Code §1202, if the stock has been held for at least five years. This is a huge win for investors and allows them to save a lot on taxes.
(Need help on taxes? Check out these guys.)
Example
Let’s consider an example.
Ben starts a company called Walli and files as a Delaware corporation. Ben is a shareholder, a director, and an officer. He opens a business bank account for Walli. He sleeps in peace knowing that he is not personally liable for the debts or actions of the company. If someone were to sue him for making a bad business decision he’d be protected by the business judgment rule unless he was super negligent of his duties. If someone were to sue him for unpaid debts, he’d be protect by the corporate veil, which is the limited-liability aspect of the corporation.
Ben gets his first investor, Sam. Sam invests money into the business and becomes a shareholder and a director. After the first year, Walli has made some substantial income. This income is taxed at the corporate rate. Then Ben and Sam get paid through dividends. This dividend payment is also taxed. Walli is in a good place to accept large investments and grow quickly and even become a public company.
LLCs
The limited-liability company first came into existence in 1977, thanks to Wyoming. Previously, all that had existed were the sole-proprietorship, the partnership, and the corporation. Here are some key points about LLCs.
Wyoming created the LLC to allow business owners to create entities that were managed and taxed like partnerships but protected from liabilities like corporations. It is a hybrid between a partnership and a corporation; because of this flexibility, many small businesses choose to be LLCs. For most growth startups, this structural flexibility isn’t actually a benefit because investors will demand to be on a board and govern the entity like a corporation.
Here are some key points about LLCs. LLCs
- Protect members from liability
- Have a simple governance structure not preferred by venture capitalists
- Are taxed once.
LLCs protect founders from liability.
In the same way that owners are protected from liability with a corporation, owners of LLCs are also protected from liability. This makes it low risk for entrepreneurs. However, the corporate veil can still be pierced, and they can be liable, in certain cases.
LLCs aren’t preferred by venture capitalists.
The structure of an LLC is simpler than that of a corporation. An LLC requires fewer documents to start up. Instead of shareholders and directors, an LLC just has members. Members hold a percentage of membership interest, representing how much of the company they own.
LLCs enjoy pass-through taxation.
The most attractive feature of the LLC is pass-through taxation. Pass-through taxation means money passes through an entity and is only taxed at personal level of the owners. Depending on tax rates, this allows for a lower overall tax rate for owners. LLCs are often called flexible. This is largely because they can actually choose between pass-through taxation and double taxation. Pass-through taxation generally has little effect on startups because founders can’t benefit from pass-through losses. Additionally, investors don’t want to pay taxes on pass-through taxable income.
Example
Let’s consider another example.
Yuri starts a company called Waftify and files as an LLC. Yuris is the single-member owner of Waftify. He opens a business bank account for Waftify. Like Ben, in the previous example, Yuri can sleep in peace, being protected by the corporate veil from personal liability. Yuri gets his first investor, Sam. Sam invests money into the business and becomes a member-owner and takes a membership interest in Waftify. After the first year, Waftify has made some substantial income. This income passes through the LLC and is only taxed once on Ben’s and Sam’s personal tax returns. Waftify is in a good position to grow at a slow pace, not relying on outside investments.
Taxation
Many founders we work with get confused by the large number of entity options. They also don’t understand that the IRS sees entities differently than other parties.
An entity is viewed differently from different perspectives. Most of the time an entity is identified as the organization it filed as. The IRS, however, sees the entity as the type of entity it checked the box for on its tax return. For example, most of the time a corporation is treated as a corporation, but for the IRS, a corporation could be a c-corporation or an s-corporation.
The IRS will classify an entity as either a corporation, a partnership, a cooperative, or a disregarded entity. Here are some points to remember:
- Corporations that are treated like corporations are called C-corps
- Corporations that are classified as corporations but treated like partnerships are called S-corps
- LLCs can be classified as either corporations or partnerships.
Sum-up
So we’ve gone over the different features of Corporations and LLCs. It’s kind of like choosing your race in a role-playing game—choosing between dwarves or humans. Here’s what to remember about each
Corporations
- Protect founders from personal liability
- Provide a familiar and scalable governance structure preferred by venture capitalists
- Are subject to double taxation, but this isn’t a big deal because of low corporate tax rates and tax-free §1202 QSBS exits
LLCs
- Protect founders from personal liability
- Provide a simple and flexible governance structure not preferred by venture capitalists
- Are subject to pass-through taxation which can be as much of a detriment as a benefit to early startups
What Savvi Can Do For You
We’ve tried to simplify this discussion of corporations and LLCs, but things become complicated quick as we dive down into the weeds of entity formation. Savvi can help with your decision. There are lots of ways to get legal work done, but in our view Savvi is best. At Savvi, we combine technology with actual experienced attorneys to provide expert legal services efficiently. Savvi helps founders get legal work done quickly and properly so they can sleep well at night and get on to doing what they do best: building their business.
Since filing as a c-corporation is the most common choice for founders we work with, we have streamlined the process to provide it at a great price and great efficiency to you, the founder.
Form your entity here.
Convert from an LLC to a C-corp here.
FAQ
Which entity type is best for me?
Most founders we work with are creating high-growth startups. For these folks, forming a c-corporation is the best route because it is a necessity for receiving venture capital money and scaling quickly.
Which entity type is more work?
C-corporations generally require more paperwork and administrative maintenance than LLCs. That is why Savvi is here to help.
Glossary
Corporation
A corporation is an organization that is legally authorized to act as a single entity, or legal person. It is an entity filed as such with a state. It includes shareholders, directors, and officers.
LLC
An organization legally authorized to act as a legal person. It provides protection from liability to its owners and appreciated for its flexibility between pass-through taxation and double taxation.
B-Corp
A benefit corporation, b-corp, is a recent type of corporation that includes having a positive impact on society within the best interest of the corporation and amongst its legally defined goals. It is authorized in 33 US states.
C-Corp
A c-corporation is an entity classification of the IRS. The default for corporations is to be a c-corporation: a corporation that isn’t an s-corp is a c-corp. It is preferred by venture capitalists and most of our high-growth, technology startup clients choose to be a C-corp.
S-Corp
An S corporation is an entity classification of the IRS. Corporations can opt to be an S corp if it is a closely held corporation. S corps are subject to pass-through taxation, meaning the entity itself does not pay income taxes. Companies that begin as an S-Corp and then transition to a C-Corp do not enjoy the benefits of a tax-free exit under S1201.
Non-Profit Organization
A non-profit organization is a legally formed organization that is dedicated to furthering a social cause. Instead of paying out surplus income to shareholders, it invests all of its surplus in furthering its mission. Non-profits are tax exempt, meaning they do not pay income tax.
501(c)3
A 501(c)3 entity is a standard non-profit organization. “501(c)3” refers to the section of the tax code that refers to these entities. Most churches are 501(c)3s.
501(c)4
A 501(c)4 is also a nonprofit, but one that can be engaged in policy advocacy and political campaigns. The NRA, AARP, and Miss America Organization are all examples of 501(c)4s.
General Partnership
General partnerships are a bad idea. The founders are personally liable for the partnership, that means the founders’ personal assets can be seized for the debts of the partnership. Today, no one really forms general partnerships except by accident. People who form C-corps improperly can be determined to actually be operating as a general partnership. And that is really bad news.
Sole Proprietorship
By default, businesses are a sole proprietorship. This means there is no actual legal entity other than the individual running the business. This is a dangerous situation, as the founder will be personally liable for all actions.
Limited Partnership
A limited partnership is similar to a general partnership and is also a bad idea.
Limited Liability Partnership
Limited liability partnerships are common entities for law firms and professional practices. Like in an LLC, the founders are protected from personal liability.
Professional LLC (PLLC)
Professional limited liability companies are just like a regular LLC, but they are owned by professionals. Some states require professionals like lawyers, doctors, architects, engineers, accountants, and chiropractors to form as a PLLC rather than an LLC.
The Savvi Founder 