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Which type of entity should my startup be?

FormationEntity choiceTax

The choice comes down to two questions: who will own the business, and how will its profits reach them. A company that will sell stock to investors and options to employees should be a C corporation, because that is the structure investors will fund, the only one that can sell preferred stock to investors alongside cheap common stock for the team, and the only one whose stock can be qualified small business stock. A business owned by its founders that will pay its profits out to them each year is usually better as an LLC, taxed once as a partnership. An S corporation is a corporation with a pass-through tax election, suited to a small, US-owned, owner-operated business, and a poor fit for anything that will raise money.

The four forms

A sole proprietorship is one person doing business with no entity at all, and no liability shield. A partnership is two or more people doing business together, taxed once at the partner level, with general partners personally liable. A corporation is a separate legal person owned by stockholders, run by a board, with limited liability for everyone and its own tax return. An LLC borrows the corporation's liability shield and the partnership's tax treatment, and is governed by an operating agreement the members write themselves. Every state offers all four, and the state you form in does not limit where you operate.

Who will own it

Venture funds and most angel groups invest in C corporations. Funds raise from pension plans, endowments and foreign investors who cannot hold pass-through income, so an LLC or S corporation is either off limits to them or requires a conversion first. Employees understand stock and options; they do not understand profits interests in an LLC, and incentive stock options exist only for corporations. A corporation can also issue two classes of stock, cheap common for the team and preferred for investors, which is the whole mechanism of startup equity and which an S corporation cannot do.

How profits will come out

A C corporation pays tax on its profit, and stockholders pay again on dividends. That is a real cost for a business that distributes cash each year, and no cost at all for a startup that reinvests everything and expects its owners to be paid by selling their shares. Gain on a sale of stock is taxed at capital gains rates, and if the stock qualifies as QSBS, some or all of it is not taxed at all. A business that will pay out profits, a consultancy, an agency, a studio, is usually better as an LLC.

Arabella forms C corporations and LLCs in all fifty states and DC. We do not suggest an S corporation for a startup, and we do not make the election as part of a formation; a company that wants one files Form 2553 with the IRS after it exists.

Written by the lawyers who built Arabella. This is legal information, not legal advice for your situation, and reading it does not make us your lawyers. For a real dispute or a high-stakes decision, talk to a licensed attorney. More questions.