Startup Structure

Innovators Wanted

Choosing a suitable legal structure is a high-priority decision for any startup.

The legal structure under which you choose to operate should merit careful consideration. It is critical that you identify the structure that appropriately aligns with your short and long-term business goals and provides you optimal legal protection.

These are the three general entity categories to consider when forming a new venture:

  1. Non-profit entity
  2. Corporation
  3. Tax flow-through entity, e.g., LLC or LP

Entrepreneurs are increasingly interested in establishing some aspect of nonprofit contribution to fund philanthropic efforts or social ventures. We will be updating this website with more information on this and, in particular, the emergence of the “B” corporation.

The two primary entity structures used by entrepreneurs pursuing for-profit business ventures are the corporation and the tax flow-through entity, otherwise known as a limited liability company (LLC).

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A corporation is the most common entity structure utilized in the United States. From a tax standpoint, this entity is viewed as a living taxpayer. As such, it is responsible for filing tax returns at the federal and state levels and for paying tax on income generated (or carrying forward losses, if applicable). In simple terms, if a corporation makes money, it must pay income taxes at the federal and state levels. If the corporation seeks to distribute its earnings to stockholders, it first declares and then pays a dividend to its owners or stockholders. Upon receipt of dividends, the recipient stockholder must pay taxes. These two levels of tax are commonly known as the curse of double taxation.

Since many startups do not expect to generate income in their early years, or pay dividends over the course of their life cycles, the curse of double taxation may be illusory. Further, as a company becomes profitable, there are steps it may be able to take to reduce its effective corporate tax rate. In the meantime, the advantage of a corporation is that it is a flexible, predictable and relatively inexpensive to form and manage. Prospective investors may also prefer or even require that the entity in which they invest be a corporation.

To the extent that a founder forms a corporation, he or she may have the ability to file an “S” election with the U.S. Internal Revenue Service (IRS). By doing so, the entrepreneur essentially elects to have the IRS treat the entity as a tax flow-through entity for tax purposes. In order to qualify as an “S” corporation, the entity must satisfy certain conditions, including having only individual U.S. citizen or resident stockholders, fewer than 100 stockholders, and only one class of stock outstanding. More information is here.

Tax Flow-Through Entities

From a taxation standpoint, a tax flow-through entity can include a limited partnership (LP), regular partnership or a limited liability company (LLC). None of these entities are viewed by taxation authorities as taxpayers. Instead, the equity owners of each of these entities are deemed to be the recipients of any income or loss generated by these entities, and they are thus responsible for income taxes attributable to the income generated by these entities. Instead of being paid by the entities that are generating the income, taxes on such income are instead owed by the entity’s equity owners. As a result, these entities benefit from a single layer of taxation.

Intuitively, founders often conclude that an emerging company should be structured as a tax flow-through entity in order to take advantage of this inherent tax benefit. The opposite, however, is more often the case. This tax benefit may have no value to the equity owners when the entity is generating losses (as the equity owners must have qualified income from other sources in order to take advantage and offset such income with losses from the flow-through entity in which they are owners). Further, when income is generated the equity owners typically expect the entity that generated that income to distribute sufficient funds to address the tax owed on such income. However, there may be better uses for such funds. Also, certain institutional investors that manage ERISA funds may be prohibited from holding a direct equity interest in a flow-through entity.

With that in mind, a common practice is to form an emerging company as an LLC with the expectation that it can take advantage of the tax benefits in its early stage and re-file as a C corporation as the company seeks institutional investors. When considering this approach, be sure to factor in the additional costs as they may not outweigh the expected benefits.

Choosing a State of Incorporation

Choosing a domestic state in which to form your company and transact business is not a decision that should be taken lightly. Most states offer benefits to companies that are formed and subsequently operate under their jurisdictions. You should consult with local taxation authorities to see if these periodic incentives can benefit your startup.

That said, more entities are organized in Delaware than any other jurisdiction in the United States. The reasons for this includes the fact that the corporate law promulgated by the Delaware legislature, when combined with its interpretations by the Court of Chancery, Delaware’s highly-regarded business court, has evolved into the most comprehensive, well-understood body of corporate case law in the nation. This breadth and clarity of the laws governing the rights, obligations and liabilities of directors, officers and stockholders reduces the costs of operating a business.

There is also a less intellectual reason that entrepreneurs favor Delaware: prospective investors are most familiar with the laws governing Delaware corporations and often prefer to invest in companies with common attributes. Many industry experts will tell you that prospective investors are searching for reasons to decline investment opportunities, and the fewer reasons a startup gives such investors the easier it will be for the startup to raise external investments.