Tech Start-Ups: Choosing a legal entity
Choosing a legal entity for your tech start-up is a tricky decision. S-Corps, C-Corps and LLC’s differ in structure, governance, taxation, fundraising, ownership, and employee compensation. Evaluate your company’s goals, for example, will you have foreign investors? Your goals will determine which legal entity best suits your business.
C-Corps are favored by outside investors. This is mainly because C-Corps can issue separate classes of stock allowing for various protections and share valuations. A C-Corp can have unlimited stockholders. Shareholders may transfer their ownership freely without compromising the continuing existence of the corporation. This means that the existence of the entity is not affected by the death or withdrawal of a shareholder. You’ve probably heard that C-Corps are subject to ‘double taxation.’ All this means is that the earnings of the C-Corp are taxed once at the corporate level on the corporations’ taxable income, and again at the stockholder level upon distribution or dividends. C-Corps are managed by the board of directors and can therefore transact business without shareholder participation. Although the board is still subject to formalities imposed by the legislature and the courts, C-Corps are generally flexible to manage.
S-Corps receive pass though taxation. This means that shareholders are taxed on their allocated share of the business’s profits but not on distributions from the corporation provided that the distributions do not exceed the cost basis of the S-Corp. In simpler terms, the corporation itself is not subject to federal income tax. S-Corps are limited to 100 domestic shareholders (U.S. citizens or residents.) Similar to a C-Corp, an S-Corp has perpetual existence and the death or withdrawal of any shareholder does not affect its existence.
An LLC is a relatively new business structure allowed by state statute, it is essentially a partnership that enjoys limited liability similar to a corporation. LLCs are easier to maintain than corporations because there is no requirement that decisions be authorized by a formal vote of a board of directors. The members of an LLC generally enjoy the same type of limited liability protection that is enjoyed by stockholders of a corporation. LLCs provide more protection against potential liability than does a corporation, primarily because there are fewer corporate formalities to comply with an LLC. LLCs however are not attractive if you intend to attract venture capital or multiple rounds of funding.
Although an LLC may be the best entity for a consulting company, if your tech start-up intends to have employees and provide equity incentives or fringe benefits a C-Corp may be your best bet. Layout out your goals, and speak to an attorney or accountant to better evaluate which legal entity will provide the best avenue for structure, taxation and employee compensation.