Entrepreneurs should carefully consider entity choice and incorporation location. They will impact business decisions, tax treatment, type of equity compensation, and ability to quickly scale.
A great approach to making the right decision for incorporation is to begin with the end in mind.
While you cannot predict the future, you can think through your intended actions: do you plan to bootstrap or raise money, scale or remain as a small team, and reinvest business earnings or pay them out in compensation? These decisions will help you select the most appropriate entity and location.
While you begin thinking about these decisions, I highly recommend you check out this video from Techstars: 10 Things You Can Do To Screw Your Company.
What Type of Entity?
The choice for many entrepreneurs will come down to (i) LLC or C Corporation and (ii) whether or not to elect S Corporation tax treatment.
For technology or other growth companies planning to scale, issue equity to employees and other service providers, raise multiple rounds of investment, and reinvest capital into the business with the goal of a big sale, a C Corporation is typically the better choice.
LLCs and C Corporations provide limited liability protection to shield personal assets from business liabilities, but they differ in tax treatment. LLCs are tax flow-through entities, which means that the LLC’s owners pay tax on the income of the LLC that is allocated to them based on the LLC operating agreement. C Corporations are subject to double taxation: at the corporate and shareholder levels.
[ibimage==29206==Medium==none==self==ibimage_align-left]
Due to tax treatment and fewer formal requirements, LLCs are the entity of choice for businesses financed by a small number of individuals, not planning to scale or raise several rounds of investment. However, LLCs can require complicated operating agreements and professional investors often cannot and will not invest in LLCs.
LLCs and C Corporations are eligible to elect S Corporation tax treatment. This tax treatment can be beneficial when the corporation is profitable and distributes substantially all of its profits to the stockholders, or when the corporation incurs losses and the stockholders wish to utilize the loss deductions on their personal income tax returns. However, S Corporations are limited to one class of stock (meaning no preferred stock financings) and 100 U.S. stockholders. For these reasons, S Corporation tax treatment will not work for businesses with foreign investors or investors that require preferred stock.
When & Where Should I Incorporate?
A business should incorporate early in its existence, and in the State where it is headquartered or in Delaware.
How early a business should incorporate will depend on when the business hits certain milestones. These milestones include: more than one founder, multiple parties creating IP, entering business contracts, and hiring/issuing equity compensation to employees.
Delaware is a recommended choice because it the legal home to many large corporations and features a set of predictable, business friendly corporate laws. It is also the preferred state of incorporation for many professional investors. Businesses not planning to raise venture funding, and most companies do not, can save money and time through decreased taxes and organizational complexity by choosing the state where the business is headquartered.
(image credit: shutterstock)
--
Joel Jacobson is an associate attorney with RUBICON Law Group, Ltd. He practices business law, including formation, contracts, transactions, and securities and enjoys the opportunities it provides to work with innovative companies throughout the United States. Joel has an interest in topics impacting the Colorado entrepreneurial community, skiing, and hiking. He can be reached on Twitter, LinkedIn, or Google Hangout.
Obligatory Disclaimer: This document is for informational purposes and is not legal advice. Your receipt of this document does not create an attorney-client relationship. You should not rely upon this information for any purpose without seeking legal advice from a licensed attorney in your state. We expressly disclaim all liability with respect to actions taken or not taken based on any or all the contents of this document.