Company Structure, Formation & Corporate Basics

Determining the right type of entity to create

Starting a company is risky, and many fail. Even if things go well, someone might sue the business. One of the primary reasons for operating your business through a legal entity is to shield your personal assets from claims made by the creditors of the business. If you operate the business through a corporation or a limited liability company (often called an LLC) then the owners and operators of the business will not generally be responsible for the liabilities of the business. Other legal structures like partnerships don't offer the same protection for all owners of the business. So between an LLC and a corporation, what's the best structure for you?

One of the key considerations in choosing the type of legal entity is the tax treatment of the entity. Every dollar earned by a Subchapter C corporation is subject to tax at the corporate level. If the corporation then distributes that same dollar (net of the corporate tax) to the shareholders, it is subject to tax a second time at the shareholder level. This so-called "double taxation" is a major cost to any entity that will be generating and making to its shareholders. In contrast, LLCs and Subchapter S corporations are referred to as "pass through entities" because corporate —even if distributed to the shareholders—generally are taxed only one time: at the shareholder level. Similarly, the owners of an LLC or Subchapter S corporation may be able to offset personal income from other sources against losses of the business, thereby reducing their personal tax burden. 

So it would seem to make sense that most every business should be structured as an LLC or Subchapter S corporation. Then why is it that most technology and life sciences are structured as Subchapter C-corporations?

First, most technology and life sciences startups won't generate any for some time, and when the business begins generating , that amount is typically reinvested back into R&D and expanding the business rather than being distributed to the owners of the business. So for these startups, there is no "double taxation." Moreover, most founders of these types of startups devote their full-time to building the business, so they don't have other income that can be offset against the losses of the business. 

Finally, there are a number of non-tax reasons most technology and life sciences startups are structured as Subchapter C corporations. Subchapter S corporations can't have more than one class of or entities as shareholders, for example. So a Subchapter S corporation is not possible if the business is to be venture-backed since venture investors typically get and are legal entities themselves (typically formed as partnerships). Similarly, there are sometimes negative tax consequences to the of venture funds that invest in LLCs. Moreover, ISOs can't be granted in LLCs. And, significantly, the legal, and other administrative costs of an LLC typically outweigh the benefits (if any) of operating most high-growth companies as an LLC. As a result, if you plan to start a business that will rely on outside capital, utilize equity to compensate employees and other service providers and seek rapid growth to sale or IPO, the best type of legal entity is most likely a Subchapter C corporation.

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