Legal Entities

Classifications

Business entities are ways to classify the organization of your business as recognized by law. While you have many entity options available to legally form the business, there are three that merit particular attention because they are common entities for technology-driven startups: C corporations, Limited Liability Corporations (LLCs), and S corporations. These entities differ significantly regarding taxation, ownership, fundraising, governance, and employee compensation.

Selection of the business entity that best suits a particular start-up should be done with the consultation of an attorney and/or accountant who has experience advising startup companies. 

The following is meant as an introduction to common business entities and should not be construed as professional advice.

C Corporations

C corporations are separate taxable entities from their shareholders. Consequently, the earnings of a C corp are generally taxed twice: first at the corporate level based on the taxable earnings of the corporation, and then at the shareholder level based on distributed dividends. C corporations may have an unlimited number of shareholders who are not required to manage the corporation’s day-to-day operations.

 Generally, venture capital investors prefer to invest in C corporations because of a C corp’s ability to issue preferred stock to investors. The structural accountability of a C corp is well- defined, with management reporting to the board of directors. C corporations can issue incentive stock options to employees, giving employees an equity stake in the success of the corporation.

LLCs

For tax purposes, LLCs are flow-through entities. Corporate revenue is not taxed at the corporate level but passes through to the LLC’s owners, where it is taxed at the individual level. Like C corporations, LLCs may have an unlimited number of owners. However, transference of ownership is more difficult, usually requiring the approval of the other owners. For this reason (among others not touched on here), venture capital investors generally do not favor investing in LLCs.

Additionally, the pass-through tax treatment of LLCs can cause undesirable taxable income to investors. LLCs generally operate without the formalities of a C corp, with the owners managing the day-to-day operations. An LLC may offer membership interests to employees but cannot offer incentive stock options.

S Corporations

S corporations, similar to LLCs, are generally flow-through entities for tax purposes, with the S corp’s taxable income distributed to its shareholders in equal proportion to their ownership share. S corporations may have no more than 100 shareholders. Additionally, the shareholders must be individuals, with some limited exceptions.

Like C corporations, S corporation ownership transference is flexible. However, S corporations do not have the ability to issue multiple classes of stock. Most venture capital investors want preferred (rather than common) stock as a condition of the investment. Consequently, S corporations are generally unattractive to professional investors.

S corporations closely mirror the accountability standards of C corporations. S corporations may issue incentive stock options to employees. However, unlike C corporations, Federal law restricts S corporations from issuing stock to certain individuals, most notably non-U.S. citizens and non-U.S. residents. 

Business Entities at a Glance

Courtesy of Singleton Law Firm, P.C.
 C CorpLLCS Corp
Liability
  • Shareholders are not typically responsible for the debts of the corporation.
  • Members are not typically responsible for the debts of the LLC.
  • Shareholders are not typically responsible for the debts of the corporation.
Tax Implications
  • Taxed at the entity level. If dividends are distributed to shareholders, dividends are also taxed at the individual level.
  • No pass through of income or loss.
  • Double taxation if income is distributed to shareholders as dividends.
  • If properly structured there is no tax at the entity level, income or loss is passed through to members.
  • No double taxation.
  • No tax at the entity level.
  • Income or loss is passed through.
  • No double taxation.
Complexity of Formation and Management 
  • State filing required.
  • Board of directors, annual meetings, and annual reporting.
  • Managed by board of directors who are elected by shareholders.
  • State filing required.
  • Some formal requirements but less formal than S and C corporations.
  • Members have an operating agreement that outlines management responsibilities.
  • State filing required.
  • Board of directors, annual meetings, and annual reporting.
  • Managed by board of directors who are elected by shareholders.
Effect on Ability to Raise Capital
  • Shares of stock are sold to raise capital.
  • No limitation on the number of shareholders, different stock classes allowed (which is preferred by investors).
  • Possible to sell interests, through subject to operating agreement restrictions.
  • No limitation on the number of members, and different classes of ownership are allowed.
  • Shares of stock are sold to raise capital.
  • Limited to 100 shareholders. Only one stock class allowed. Only U.S. citizens and residents may hold shares.
  • Easier to convert to a C corp than and LLC if venture capital is sought.

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