Choice of entity: Five items to consider when choosing your startup entity structure
Trent Dykes and Michael McClain
One of the first major decisions the founder of a startup will need to make is regarding choice of entity. While there are numerous different forms of entities to choose from, the three most commonly utilized by startups are: limited liability company (LLC); C corporation; and S corporation. Each type of entity has its own advantages and disadvantages. Below are five items to consider when choosing your startup entity structure.
S corporations and LLC’s are what is called “pass-through” entities: they do not have an entity-level-tax. Instead, it is the owners (shareholders and members, respectively) responsibility to pay taxes on the entity profits relative to their ownership portion. As such, these entities only pay a single layer of tax at the owner level (on the owner’s individual tax return). C corporations on the other hand pay at both the C corporation-level and then again at the owner level—so two levels of tax.
A C corporation’s profits are taxed separately from its owners (the shareholders); therefore, a C corporation’s shareholders are not subject to self-employment taxes on the corporation’s income. S corporation shareholders are also not subject to self-employment taxes because S corporation shareholders, who are also employees, are treated as employees and shareholders in their distinct capacities (as long as they are paid “reasonable compensation” for their services rendered). In contrast, all income of a member-managed LLC engaged in an active business that is allocated to a member is treated as self-employment income of the member – and this is true whether or not the income is distributed to the member.
Equity incentives and financings—
C corporations and S corporations can both easily issue employee stock options and are eligible to issue “incentive stock options” (which are afforded special tax treatment under the IRS code). In contrast, it is much more complex for an LLC to design and implement an employee equity incentive program that mimics traditional employee stock options, and an LLC cannot grant “incentive stock options.” C corporations can engage in traditional VC-style preferred stock financings while an LLC and S corporation cannot (although, while more complex, an LLC can structure its membership interests to mimic a preferred stock structure).
S corporation eligibility—
C corporations and LLC’s are not limited with respect to ownership (e.g., both who can be an owner and what type of equity can be issued) whereas S corporations do have strict ownership limitations imposed by the IRS. For example, S corporations are limited to 100 shareholders and these shareholders must all be U.S. citizens or resident aliens (i.e., no foreign or entity shareholders), and S corporations may only issue one class of equity (common stock).
Ease of conversion and mergers—
Converting an S corporation to a C corporation is simple. Converting an LLC to a C corporation, a C corporation to an LLC or a C corporation into an LLC is much more complex. For example, an S corporation automatically converts (from a legal perspective) to a C corporation once it violates one of the IRS S corporate eligibility rules. Additionally, C corporations and S corporations can participate in tax-free reorganization under the IRS code, while the ability of an LLC to participate in a tax-free reorganization is much more limited. This limitation could prove to be costly if your startup is acquired in a stock-for-stock merger – as without the benefit of the IRS tax-free organization rules, the stock received as consideration for the ownership in your startup would be taxed (even if such stock received was illiquid).