Choosing your company’s legal entity is the first important legal decision you will make for your startup. For many entrepreneurs, this is probably a distant thought.
Your legal entity choice is predominately dependent upon 3 major questions: 1) how do I protect myself from lawsuits against the company, 2) how will you fund the company, and 3) what entity will give you the best tax benefits? This varies significantly based on the industry your company plans to operating in. While this blog post will significantly focus on the technology startup world we plan to expand this reasoning and applicability to other industries and geographic locations . . . so stay tuned.
The three major legal entities in the technology startup space are the Delaware Corporation (“DE Corp”), the Corporation in your company’s home state with an S-Corp election with the IRS (S-Corp) and the Limited Liability Company (“LLC”) in your company’s home state. They are each discussed in greater detail below accompanied by great insights from some of the best startup and small business attorneys in Silicon Valley and other tech hubs. Because of the legal and tax implications, make sure to run any decisions by your legal and tax professional.
- What is it? There are a number of differences between Delaware’s corporate code and other states like California. These differences make Delaware more flexible and advantageous for venture capitalists and their lawyers, which is why is has become the gold standard for startups. A corporation in general offers a number of advantages over other entities like an LLC (as explained by Attorney Yoichiro (“Yokum”) Taku of Wilson Sonsini) when operating a startup like flexible equity investing and the ability to create employee stock plans (great Quora answer by SV attorneys).
- When to use? Nearly every startup attorney would agree, that if you plan to raise institutional money (a.k.a. VC money) AT ANY POINT then you should form a DE Corp. If you do not plan to raise institutional money then many attorneys would suggested forming your company in your home state.
- What to do? See How To Form A Delaware C-Corporation.
- What is it? Entities which have a corporation structure but have elected to report their flow-through income and losses on their personal tax returns with the IRS. This allows S corporations to avoid double taxation on the corporate income. There can be significant tax saves when forming as a S-Corp if it is done correctly, but there are a number of qualifications to be an S-Corp. S-Corps can still have employee stock plans just like a corporation.
- When to use? There are a number of situations where an S-Corp makes sense. – you should have this discussion with your tax professional. A number of tax professionals agree that single person independent contractors and some small closely held organizations (like tech outsourcing groups) should always form as S-Corps because of the potential tax savings. You should consult your tax advisor to make sure you business model will reap the highest tax savings under an S-Corp. Sometimes, Delaware Corporations who do not plan to raise VC money until after they are making revenue, will temporarily elect to be an S-Corp to reap the tax benefits and then will un-elect immediately prior to raising VC money (it is very easy to un-elect).
- What to do? Forming an S-Corp is almost identical to forming a corporation except that the company files a IRS form electing to be an S-Corp. See How To Form A California S-Corporation. See also the Independent Contractors Guide.
- What is it? They were intended to serve as an alternative to partnerships – to provide the “corporate” vail to partners. Because of their ease of formation, many online companies have pushed LLCs for the decade. LLCs can opt to be taxed in a as a corporation or S-corporation.
- When to use? In certain partnership arrangements, when there is no need to have outside investors, no need for an employee stock plan and under certain business models an LLC will make sense. Again, you should consult your tax professional for a precise evaluation of these factors.
- What to do? See Guide to Forming a LLC
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