Choosing how to incorporate your business can have huge implications down the road. From understanding tax implications to properly setting yourself up for future investment and growth, you have a lot riding on your choice.
There are a few different entity types that you can set up when you incorporate. Each type has its pros and cons, depending on what kind of company you’re building. The two options entrepreneurs tend to consider most often are limited liability companies (LLCs) and C-corps, but even with just those two options, it can be daunting to understand which route to go. We’ll break down the key differences you should take into account, then provide some examples of each at the end.
- Companies that are looking to raise funding from VCs or institutional investors in the near future should generally incorporate as a C-corp, as those sources of capital will almost always require it.
- If your business doesn’t need that type of investment, then an LLC offers protection from personal liability and additional options for tax structuring—while also being more flexible to manage.
- The Carta Incorporation Resources tool makes it easy to determine how best to take this important step. Answer a few questions, learn what might be the best approach for your particular company, and get introduced to providers and law firms.
What is an LLC?
An LLC is a common type of legal entity that offers a relatively simple way to protect you and your partners from personal liability, secure the company’s intellectual property (IP), and bring on certain partners and investors. If you’re starting to draw up business contracts or have IP that you need to protect, an LLC can be a good route for formalizing your company.
Less complex company structure
Overall, LLCs have fewer legal requirements related to corporate governance that they need to abide by when compared to corporations—which makes them an attractive choice for many companies. C-corps, on the other hand, need to observe corporate formalities and governance requirements dictated by state law, including holding regular board and shareholders’ meetings. It can be recommended that LLCs follow similar procedures, but they’re not legally required to do so.
Pass-through tax benefits
That said, a main consideration when choosing an LLC are the tax implications for the business. LLCs are able to “pass through” taxes to its members, meaning that profits and losses aren’t recognized by the LLC itself, but rather by all LLC members on their individual tax returns. This can have the added benefit of avoiding the “double taxation” seen with C-corps—where the corporation itself pays taxes on its profits, and distributions to shareholders are also subject to tax.
For example, let’s say a company loses $500,000 in its first year of operating. If it’s formed as an LLC, those losses can be passed on to the individual members, who can use the losses to offset certain types of income. Or, if the company had the same figure in profits, those profits would flow down to the individual members and be taxed at their personal tax rate.
Founders should be aware that this benefit has been reduced in recent years, says Anthony Millin, founder and co-chair of NEXT powered by Shulman Rogers, a legal practice focused on startup and emerging growth companies. “While avoiding double taxation by filing as an LLC is attractive, it’s important to recognize that the corporate tax rate was cut from 35% to 21% in 2018, making the double tax hit not as significant as it previously was.”
Ability to accept certain types of investment
Starting a business is tough, and bringing on the right partners to help along the way can be crucial to making it to the next milestone. If you’re looking to have friends and family as investors, an LLC could be a great way to do so without incurring too much overhead work. Or, if you’ll be sticking it solo and leaning more on business loans, a sole proprietorship could be a better way to go without giving up equity.
What is a C-corp?
A C-corp is another type of legal entity that also shields its owners from personal liability, while enabling the company to have a wider pool of potential investors. That said, a C–corp is more complicated to run due to tax and state regulations they must abide by.
In contrast to an LLC, C-corp revenues will be “double taxed,” first at the corporate level and then at the individual shareholder level when distributions are made. Unlike LLCs, C-corps are not able to “pass through” losses or profits to individuals.
Also, as discussed above, C-corps have many more regulatory requirements they need to abide by to stay in good standing with their state of incorporation. Those regulations depend on the state—but from holding regular board and shareholder meetings to taking detailed board minutes, it’s quite a lift. While this can also be a good forcing function to make sure your business is managed well, it will require material investments of time and money.
While LLCs can be simpler to manage and may provide some tax advantages to founders who want to take advantage of pass-through taxation, corporations also offer many benefits. We’ll list a few scenarios where startups should primarily consider a C-corp below.
Benefits of a C-corp
Raising venture capital
For many startups, raising multiple rounds of venture capital will be necessary to grow at the rate, and to the size, they are targeting. In most cases, venture funds and institutional investors will only invest in C-corps, making it a prerequisite for companies looking to go that route. This is driven by a few main factors, including how taxes are structured for C-corps versus LLCs, says Anthony.
“Companies can bring investors into both LLCs and C-corps, but venture and institutional investors don’t want to be part of an entity that passes through profits and losses. If you’re looking to be a high-growth company that raises multiple rounds from VCs, it will be a prerequisite to incorporate as, or convert to, a C-corp before accepting that capital.”
Joining an accelerator or incubator program
Accelerator and incubator programs focus on helping startups scale through a combination of funding, mentorship, community, and introductions to investors or business partners. Similar to VCs, these programs have a high preference for C-corps and typically shy away from accepting LLCs.
Equity incentive plans
C-corps also have the advantage of being able to offer equity incentive plans that include stock options, which is not possible with LLCs. These can be powerful tools to align everyone’s motivations at a company; team members are often more interested in helping the company hit milestones when they are able to participate in the upside created.
These tools should also be taken into account when thinking about recruiting. Who will you be competing against for the best talent? Will their other offers likely include equity? If so, incorporating as a C-corp could be the route to take instead of an LLC.
Startups will also oftentimes bring on advisors to help guide the company through pivotal moments. If this is something you may do, stock options are a common form of compensation in those cases and a C-corp will be necessary to distribute those.
Qualified small business stock (QSBS)
QSBS is an amendment to the U.S. tax code passed in 1993 that allows for startup founders, employees, and investors to realize tax benefits from their stock holdings. Eligibility was expanded in 2009 to include C-corps, covering the vast majority of early-stage startups. Generally, this means that individuals are exempt from paying capital gains taxes on a portion of stock sales as long as they’ve held the shares for at least five years, among other conditions. This benefit is only available to C-corps.
But how does this all play out in real life? As you can imagine, the answer to that question can vary widely and really depends on each unique situation. Let’s walk through a few examples outlining these considerations.
Sarah’s construction business
Sarah is looking to launch a new construction company, partnering with her friends and family to raise the initial capital and run the business. She will soon be engaging with contractors and it seems like a good time to incorporate Sarah’s Construction Company (SCC). She plans to gradually grow this business, taking on some startup capital from relatives to get up and running, and keep them on as active partners through the years.
In this case, it would likely make the most sense to incorporate SCC as an LLC. Sarah is not looking to raise large rounds of capital from venture or institutional investors, instead opting for partnering with close family and friends. She’ll also get the added benefit of passing on any initial losses that typically happen in the early stages of building a company on to her personal taxes.
The pre-seed agtech startup
Sydney and her friend Alex have made the decision to leave their current roles as senior marketing and engineering managers at a Series C agtech startup to launch a company together. Leaning on the years of experience they’ve gained in their current roles, the team will be building a company and product in that same agtech space. They have a goal of raising a small pre-seed round to fuel the building of an MVP. They then plan to take that MVP and recruit a scrappy team to find product-market fit.
As Sydney and Alex are building a company in a competitive, tech-focused space, and are looking to engage with venture capitalists in the near term to secure a pre-seed round, the two of them should look at incorporating as a C-corp. The types of investors they will be approaching for this round of funding will require that, and they’ll likely need to raise further equity funding as they prove out the startup. Further down the road, they also plan on hiring a team to help reach the next milestones. In a competitive tech market, it will be advantageous to be able to match stock options that candidates will likely be getting with other offers.
A bootstrapped fintech team
John recently graduated with his MBA and is now looking to start a company. While in grad school, he worked multiple internships with SaaS startups in fintech, leading him to focus on those spaces for this new entrepreneurial endeavor. Companies in this market often lean on each other via APIs to manage typical financial problems (identity verification, etc). The team currently comprises him as CEO and Nancy as CTO, a friend he met during one of her internships. They plan on using their own savings for the first year of development before seeking outside investment from seed VCs.
This team of two could go either route. Since they aren’t prioritizing raising venture capital in the near term, starting off as an LLC, which is a lighter lift, could save them some time at the beginning stages. Once they’ve progressed to the point of pitching VCs, perhaps they engage their lawyer to switch to a C-corp. Or, if they don’t want to worry about switching incorporation types later, they could start as a C-corp from the beginning. Since the team will be engaging with other fintech companies early on to leverage various APIs, it would be best to incorporate now as to shield the founders from personal liability.
Choosing which type of incorporation to go with for your company can be confusing, but there are a few key things to take into account. What type of investors will you be pursuing? How fast will you be looking to grow the company? What industry will you be operating in?
For a step-by-step guide to which option may suit you and your company best, check out Carta Incorporation Resources. We’ll walk you through various scenarios and offer partners that can help you formalize your decision. Be sure to also take a look at Carta Launch, our program for early-stage startups that gives you all the tools you need to understand and manage your equity.