Debra Innocenti-Placette of Innocenti Jones, PLLC is one of the top internet and cyber lawyers in Texas. Based in San Antonio, she maintains a diverse legal practice for emerging companies in technology and internet-related industries, using her tech expertise to guide clients unfamiliar with tech through complex legal issues presented by emerging technologies.
In her two-part guest post series, Innocenti-Placette frames the foundational decision every entrepreneur faces: How to determine the best legal structure for one’s startup.
Part 1, which you can read here, focused on understanding the differences between different types of founder’s purpose. It is an illuminating exploration of how the ‘why’ determines the legal ‘how’ for your business. Part 2 concludes with appropriate legal entities for each category of founder purpose.
The information in this guest post is provided by the author, not StartupsSanAntonio.com. All answers are general in nature, not legal advice, and not guaranteed. Because laws change over time and vary in different jurisdictions, it is imperative that readers consult an attorney in their area regarding legal matters and an accountant regarding tax matters.
Choosing the right business structure for your startup has long-lasting repercussions. How you pay taxes, your personal liability, and the day-to-day governance requirements depend on the way you form your business. In my last post, I explained how the structure founders select for their business should be a function of their purpose—innovation, income, or impact.
Generally speaking, there are four categories of business structures, also called forms or entity types: sole proprietorship, partnership, a limited liability company, or LLC, and corporation. Almost all are created under the laws of a particular state, usually the state where the startup owners reside. Each offers different advantages and limitations. When choosing a legal structure for your startup, the goal is to choose a structure that will be a natural fit for your purpose.
One of the most common options business owners evaluate is whether to form an S corporation (S corp) or a C corporation (C corp). These are the two most common ways to incorporate, and the choice really depends on your business goals. A C-corporation is a standard corporation paying taxes at the corporate level, while the S-corporation’s profits and losses are “passed-through” the business and reported on the owners’ personal tax returns, with income taxes paid at the individual level by the owners.
Most innovation startups are C-corporations formed under Delaware law. The “C” designation refers to the subchapter of the Internal Revenue Service (IRS) code that defines its unique tax treatment. Delaware or C-corporations are registered in the state of Delaware but may conduct business in any state, a benefit for companies with investors in different states or countries. Over 50 percent of publicly-traded corporations in the United States and 60 percent of the Fortune 500 are incorporated in Delaware to take advantage of this. C-corporations, in particular, are designed for investment, making them a good option for scalable startups that depend on investment rather than revenue.
Owners of “disregarded” entities, such as LLCs or partnerships, are taxed on the income of the business allocated to them regardless of whether any funds are distributed to them. They are called “disregarded” because, from a tax perspective, the IRS does not distinguish between the owner and the business. However, in a C-corporation, an investor is taxed only if the business pays the investor a dividend or salary. This distinction makes it easier for a C-corporation to retain and accumulate capital.
Raising capital—taking on investment—is easier in the C-corporation form because it allows for various types of ownership interests and owner types (individuals, other business entities, non-U.S. entities, and funds). C-corporations also avoid subjecting its out-of-state investors to income tax in other states or its non-U.S. investors to U.S. income tax.
C-corporations do add an additional layer of complexity to operations. The corporation will need to file documents in the state where it conducts the majority of its business activity, and it will have reporting and tax requirements in at least two different states. Decision-making is also more formal via its officers and a board of directors with some decisions made or approved by the owners.
Most businesses are formed to generate immediate and predictable income. Because there is less of a need to obtain capital by selling equity, there are often fewer owners in income businesses, who typically prefer to focus on income without the distraction of complex governance. They also want a flexible structure that can be tailored to unique circumstances. Depending on whether there is any need for liability protection, a sole proprietorship, partnership, or LLC may be a good fit. The LLC is the most popular choice.
An LLC provides the liability protection of a corporation but the taxation and operational flexibility of a partnership. The benefits of choosing the LLC as the legal structure for your startup are tax flexibility, fewer decisional formalities, and protection from liability.
The LLC owner determines how to be taxed. The owner of a single member LLC can elect to be taxed the same as a sole proprietorship. Profits or losses from the business would not be taxed directly but instead would pass through to the single member’s personal tax return. Co-owners in an LLC can elect to be taxed like a traditional partnership. Owners can even choose to be taxed as either a C- or S-corporation.
As corporations, LLCs provide founders protection from liability incurred by the LLC. Creditors may not seize personal assets of the LLC’s members. It is a meaningful protection not provided in a sole proprietorship or general partnership. With less complex and more flexible governance formalities, LLCs overall can be easier to form and easier to keep in good legal standing.
Unless you choose to be taxed as a corporation, LLCs are usually subject to self-employment taxes. This can impact personal taxes for LLC owners because profits are not taxed at the business level, but pass through to its owners who will account for those profits on their personal tax returns. These taxes for the owners can be higher than they would be at the business level.
A nonprofit corporation used to be the obvious legal structure for those founding a social impact startup, but impact founders are becoming more innovation-minded and might find greater satisfaction in for-profit legal structures. Lawmakers have introduced new legal structures like B-Corporations, low-profit LLCs (L3Cs), social purpose corporations, and flexible benefit corporations to accommodate the possibility of blended missions.
These new types of entities were created under the laws of various states in order to allow for-profit companies to legally pursue a social or environmental mission. Previously, a for-profit entity’s purpose could only be to maximize profits for the benefit of its owners and owners could be sued by the shareholders for failing to comply.
In these new for-profit structures, unlike in a tax-exempt nonprofit, founders can have ownership interests in the company and there are fewer transparency requirements. Most importantly, the company can generate business revenue to accomplish its mission. These structures (especially the B-corporation, which is certified by an organization called B Lab) do have various compliance requirements, so careful consideration should be given as to whether the form is helpful to obtain the investment needed.
Rather than feeling overwhelmed by the alphabet-soup of business structure choices, founders should start by considering where the funds will come from to finance the operations of their organization. Innovation startups must focus on obtaining investment, while income businesses rely on revenue. Impact organizations must focus on either obtaining donations as a nonprofit or generating revenue and seeking investment as a for-profit business.
By starting with purpose, the choice of structure becomes clearer for founders. Choose the legal structure that best allows you to achieve your funding goals.