INSIGHTS

Choice of Entity for the Startup Business

November 7, 2022

Structuring a Startup Business

While forming a new entity is generally quite easy, corporate structure and tax considerations play a fundamental role in a startup’s ability to raise capital. Prospective investors have expectations for how a “venture backable” business (i.e., a business with the potential to generate significant returns with a potentially high valuation) is to be organized under state law and classified for income tax purposes. However, the fundamental question for founders is: what actually makes the most sense for the business? Here we briefly discuss four structures for forming a new business and their tax classifications: (1) a state law corporation classified as a C corporation; (2) a state law corporation classified as an S corporation; (3) a limited liability company (“LLC”) classified as either a C corporation or an S corporation; and (4) an LLC classified as a sole proprietorship or partnership.

State law corporation classified as a C corporation: Assuming the new business will be venture backable from formation, then potential investors will generally expect that a Delaware corporation (or a corporation formed pursuant to other similarly favorable state law ) be formed and classified as a C corporation for tax purposes. The C corporation is generally subject to two layers of taxation, once at the corporate level and again at the shareholder level when corporate profits are distributed. Hence, in theory, the overall income tax burden on a C corporation might be higher than would be the case with a pass-through entity. Although this double taxation is generally viewed as the main argument against C corporation status, there are many other factors to consider. For example, the current federal corporate income tax rate of 21 percent is significantly lower than the highest individual federal income tax rate of 37 percent. If the founders expect to reinvest as much of their businesses’ earnings as possible and limit dividends, the after-tax cash flow of a C corporation might be greater than the after-tax cash flow of a pass-through. Furthermore, stock in a C corporation is eligible for the special tax treatment of “qualified small business stock,” or “QSBS,” for certain investors if the requirements of Internal Revenue Code (“Code”) section 1202 are satisfied. The draw for investors to invest in QSBS is that the capital gains from a future sale of the corporation’s stock held for more than 5 years may be partially or wholly exempt from tax. There are, however, many requirements that the corporation and its shareholders must satisfy in order to qualify for QSBS treatment. The basic requirements for QSBS status are that the corporation be engaged in an “active business” as defined in Code section 1202 and that its gross assets cannot not exceed $50 million before and immediately after the stock issuance. As with most areas of the tax law, the requirements for QSBS status are quite complex. Yet, if founders and their corporations satisfy the requirements, the benefits of QSBS status can be substantial.

State law corporation classified as an S corporation: Like the C corporation, an S corporation generally follows all the same formalities, processes and procedures required to operate a state law corporation. Unlike the C corporation, however, the S corporation provides for pass-through taxation, which means that the corporation itself would not be subject to income tax and that the owners of the corporation would pay the income taxes attributable to the corporation’s earnings on their own tax returns. (As a practical matter, an S corporation generally would have to make tax distributions so that the shareholders can pay their income taxes on income that is passed through.) This pass-through taxation can be attractive to founders that want to avoid the double taxation to which C corporations are subject, but it comes at a cost of restrictive ownership rules that may limit the ability to raise capital for the business going forward. For example, the basic requirements for qualifying for and maintaining S corporation status are:

• the corporation cannot have more than 100 shareholders;
• the corporation can only issue one class of stock; and
• the shareholders must be U.S. individuals (or certain trusts and estates).

The corporation cannot bring in investors that are entities, such as partnerships or corporations, which are all common sources for raising capital. Moreover, if the corporation does not abide by the S corporation rules, the corporation’s S Corporation status would terminate causing the company to become treated as a C corporation for tax purposes. S corporations are not eligible for QSBS treatment (discussed above). Accordingly, those founders that anticipate difficulty in meeting the above requirements should consider other structuring options from the outset.

Forming an LLC classified as a C corporation or an S corporation: An LLC generally provides the same limited liability protections as a corporation but with greater ease of formation and less operational formalities. Additionally, an LLC can elect to be treated as a C corporation or an S corporation (if it qualifies as an S corporation) for income tax purposes. This allows a new business to benefit from the ease and flexibility of forming an LLC, while being able to elect into C corporation or S corporation treatment for income tax purposes. These aspects may make the LLC classified as either type of corporation for income tax purposes an attractive option. However, founders must also consider the business’s ability to raise capital and whether an LLC is an attractive investment vehicle for their target investors.

Forming an LLC classified as a Sole Proprietorship or Partnership: If founders will not be looking to immediately raise capital, the LLC classified as a sole proprietorship or partnership may be the most flexible option of all. For income tax purposes, an LLC is treated by default as a sole proprietorship if it has only one member or as a partnership if it has two or more members (in either case, so long as an election to be classified as a C corporation or an S corporation, as discussed above, is not made). The sole proprietorship and partnership income tax treatment provide for pass-through taxation so that the members of the LLC would pay the income taxes attributable to the LLC’s earnings on their own tax returns. And, the founders can choose to incorporate the LLC or change its tax classification at a later date (via a “check-the-box” election) depending on the preferences and expectations of prospective investors. With a later incorporation or check-the-box election, however, the founders will have to consider whether it can be accomplished on a tax-free basis. A later incorporation delays the start of the 5-year holding period and may make QSBS treatment unavailable if the gross assets exceed $50 million at the time the LLC becomes a C corporation.

The foregoing does not take into account international tax planning, to the extent that such planning is consistent with the business plan.

Other Considerations: In addition to the tax considerations discussed above, founders should also consider the corporate formalities and annual requirements imposed on business entities at the state level, all of which may vary from jurisdiction to jurisdiction.

By way of example (and by no means an exhaustive list), all corporations incorporated in Delaware are required to file an “Annual Report”, pay an annual “Franchise Tax,” which is in addition to any federal income taxes, conduct annual meetings, and elect a board of directors.

• Annual Report: The information required in a Delaware annual report is the address of the corporation’s physical location, the name and address of one officer, and the names and addresses of all corporation directors. These details must be submitted each year, even if no changes were made from the previous year.

• Franchise Tax: The annual franchise tax can be calculated using one of the following methods: the “Authorized Share Method” or the “Assumed Par Value Capital method”. Founders should use the method that results in the least amount of tax.[1]

• Annual Meeting: Delaware law requires every corporation to hold an annual shareholders meeting at least once every 13 months. Generally, the date of the annual meeting is provided in the bylaws of the corporation and it must be held, regardless of the number of shareholders.

• Board of Directors: Delaware law requires that every corporation elect a board of directors. In Delaware the minimum requirement is one director, however, other jurisdictions may require more.

On the other hand, LLCs are generally given much more flexibility when it comes to corporate governance matters. For instance, most states, including Delaware, do not require LLCs to hold annual member meetings or elect a board of directors (LLCs are typically “member managed” or “manager managed”, but founders are able to set up a management structure of their choice in the LLC operating agreement), and at least in Delaware, founders can contractually waive a number of the duties that are imposed under Delaware corporate law. For startups with limited resources, this flexibility can be invaluable. In addition, Delaware LLCs do not file Annual Reports, but they are required to pay a flat-rate Annual Franchise Tax of $300 each year, regardless of income or business activity. The flat-rate fee can give founders comfort in knowing what amount they are required to pay each year.

In any event, founders should keep in mind that they can always convert an LLC to a corporation (or vice versa) when the time is right. Founders should discuss with legal counsel the pros and cons of each entity type and jurisdiction of formation prior to making their selection.

Conclusion

There are pros and cons to any corporate structure and tax classification. Choosing the best option depends on the founders’ plans for the business–there is no one-size-fits-all approach. Founders looking to make a choice-of-entity decision should consult with legal counsel to better understand the options discussed above and to consider potential alternatives.