Startups are the heart of any economy. In 2022 alone, five million startups were established in the U.S. But how do founders know how to structure these companies, and what else do they have to take into consideration?
Startup structures: The basics
While a founder might be clear on what they want their business to do, how it should run and the types of employees they need, startups have choices as to what entity and tax structure to choose.
A C corp is the most common structure for a technology startup. It’s recognized as a corporation under state law and taxed at the entity level.
An S corp is also considered by law to be a corporation but not taxed at the entity level. Further, electing S corp treatment requires an election with the IRS.
An LLC (limited liability company) is a more flexible structure that can be taxed as a C corp, an S corp or as a partnership.
A partnership is another type of business structure. While there are various types of partnerships, they are very rare for technology startups.
The pros and cons of each
It’s important to consider all factors when structuring a startup, as every approach carries benefits and drawbacks.
Advantages to setting up a C corp include:
- As the most common structure for a technology company, a C corp’s investors will be most familiar with this structure.
- Most startup “templates” available assume a C corp.
- QSBS treatment for your stock may be an option.
- A C corp is fairly flexible in terms of authorizing different classes of stock with different rights and preferences.
Conversely, drawbacks to establishing a C corp include:
- A C corp is taxed at the entity level. Distributions are taxed again at the shareholder level.
- This structure is less flexible than an LLC. State law generally dictates that certain matters need approval of a board of directors, and some need shareholder approval. There are also legal requirements about how board and/or shareholder meetings are conducted, what can be approved without a formal meeting, and sometimes even the order in which things are approved. State law generally also requires the number of shares and the rights and privileges be filed with the Secretary of State, with changes reflected in amended filings.
- With a C corp, deducting losses on stockholder tax returns isn’t an option.
Pros of structuring a startup as an S corp include:
- No taxation at the entity level
- The company can deduct losses on individual shareholder tax returns.
- While owners must take a reasonable salary, if the business provides services, any distributions above that can be taxed at lower rates.
Some cons of setting up an S corp include:
- It’s the most rigid structure with only one class of stock allowed, with limited exceptions. This can be problematic. For example, investors may want a liquidation preference – typically an agreement to secure their money first in any company sale or liquidation – in connection with their investment. That is accomplished by issuing preferred stock to investors and cannot happen with an S corp.
- The business cannot have entity shareholders. Therefore, a private equity or VC fund cannot invest in an S corp.
- There’s no possibility of QSBS treatment.
Finally, an LLC has several advantages:
- The business can choose tax treatment, although the default is that of a partnership.
- An LLC offers flexibility in governance structure, which can be designed to meet the needs of all stakeholders.
Setting up a new business as an LLC also has some drawbacks:
- There’s no QSBS treatment. However, if you later convert to a C corp, you may be able to take advantage of QSBS.
- Service provider owners may need to pay ordinary income tax plus self-employment taxes on all distributions.
- Assuming the LLC is taxed as a partnership, and as time passes, granting equity to service providers can get complicated, because there’s no simple equity granting solution for service providers when the company’s value grows. With corporations, you issue options; with LLCs, flexibility has led to more ways to grant equity-type interests, each of which has different tax pitfalls.
Determining the best startup structure
The most important aspect of identifying the best startup structure is considering your business’ planned trajectory.
Do you want to bring investors into the mix? If so, the company will likely become a C corp. Establishing the business as an S corp is unlikely to be a long-term option unless all investors are private individuals.
From a tax perspective, consider what losses you may want to take advantage of on your tax returns. With both an S corp and LLC (if not taxed as a C corp), any company losses pass to shareholders’/members’ tax returns. That is, if you own 10% of an S corp or LLC, and the entity has net negative income of $1M for tax purposes, $100k of that loss would appear on your K-1. That $100k loss can offset income/gains on your personal tax return.
Finally, consider whether you may eventually devise an exit strategy or keep the business running for profit.
The bottom line
It’s important to evaluate the pros and cons of each startup structure type to determine which one will best suit your new business. Weighing these factors will give you the confidence in knowing that you’re setting yourself up for success.
Statements of the author and the interviewee do not necessarily represent the editors and the publisher opinion again.