Startup 101 : Should You Form An Inc. or LLC?

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Startup 101 : Should You Form An Inc. or LLC?

 


Although the topic of business formation (Inc. vs. LLC) has been discussed in other places, it continues to be something that comes up in my conversations with startup entrepreneurs.  I’ve been avoiding writing about it because I don’t find it particularly interesting (though necessary).  Some time ago, Nicholas Napp, one of the OnStartups regulars, posted a great message on our discussion forums responding to another user’s message with a question about company formation.  With his permission, the below article is an edited version from his original posting.  All the helpful stuff is from Nicholas’ original article and all I’ve done is make minor edits.  Thanks Nicholas!

 

Disclaimer:  Neither Niicholas nor I are lawyers and the below should not be regarded as legal advice.  We strongly recommend that if you are going to start a company, you seek appropriate professional advice.

 

Having said that, I hope you find the below information useful as you educate yourself on the options.

 

Startup 101:  Should You Form An Inc. or LLC

 

In the past, I have formed startups that have been corporations (S-corps) and LLCs.  My current startup, HubSpot, was formed as an LLC. 


There are three primary kinds of entities most startup founders in the U.S. will consider:

1) LLC
2) C-corp
3) S-corp

There are a number of primary factors when trying to make the choice between these:  (a) will you be seeking outside investors – and if so, when?  (b) will the company be generating a profittha anytime soon? 


Lets compare and contrast the three types of entity.

An LLC is very easy and cheap to set up. It is also, contrary to popular belief, an entirely legitimate corporate entity. You define who the "members" are and how much each member owns as a percentage. I believe you get the same protection from personal liability as you would get from setting up a full C-corp. One of the great features about an LLC is that there is almost no regulatory BS to deal with. You are not subject to the same arduous rules /disclosures/expensive accounting that a C-corp has to adhere to.

Another big advantage is that the LLC is not taxed as an entity. The members are taxed, usually in ratio to their ownership percentages. Why is that an advantage?

A) When you are a startup, you will be losing money. Your prorated portion of that loss can be applied to your personal tax return. If you have no personal income, the IRS gives you a choice. You can roll your loss forward and use it to offset future income, or you can go back through the last three years of tax returns and apply the loss retroactively. That reduces your adjusted gross income, often leading to a refund. It can be quite beneficial in some circumstances.

B) If you are a C-corp the company is a tax paying entity -- it pays tax on all income. If the company pays you, you pay personal income tax. i.e. money coming in to the company is taxed twice by the time you get it.

Sounds good so far? LLC is a GREAT structure and is perfect for many situations. However, it does not really allow for shareholders, so if you have outside investors, an LLC is probably not going to fly.  Some type of investors (particularly VCs) have structures that do not permit them to invest in an LLC.

2) The C-corp. This is your full blown corporation (e.g supasoft inc.). A C-corp is a legal/tax entity in its own right, so you get maximum protection etc. C-Corps are often incorporated in Delaware as Delaware has a great legal framework for corporations, boards and shareholders. The issue with a C-corp is that you have to have a board of directors, adhere very carefully to certain reporting requirements and generally keep your finances and operations in good order. A C-corp has shareholders, can issue stock to anyone and is a respected and expected structure for most investors. You'll have the double taxation issue mentioned above, but if you want investors to put money in your company, you need to be a C-corp, unless you meet the requirements for an S-corp.

3) The S-corp. An S-corp is really a C-corp with special permission to behave differently. The "s" refers to a subsection of the U.S. Tax (IRS) code. You form a C-corp and then take an S-election if you qualify. You have all of the regulatory side of a C-corp, but the tax pass through advantages of an LLC. The caveat: there are significant restrictions on the type of investors. Your investors cannot be corporations (i.e. VC's) or persons non-resident in the USA. There are some other restrictions too as to the number of shareholders etc.

My personal practice has been to create an LLC (they are simple, avoid double taxation and still support multiple classes of stock if needed).  If and when the time comes to “convert” the LLC to a C-corp, the process is not that difficult.  Whatever costs you’d incur in the “conversion” process, I think are offset by the upside you get during the time that you can benefit from being an LLC.  An LLC can be setup for a few hundred dollars and likely meets the needs of most early-stage entrepreneurs.

 

There are likely many in the OnStartups readership that know a lot more about this than I do.  If you have ideas on why one or the other options makes more sense in certain situations (particularly common situations), please leave a comment.  Would appreciate your input.

 

 

Posted by Dharmesh Shah on Fri, Mar 16, 2007

COMMENTS

It also depends on the law of the state where you plan to form your business entity. In New York, formation of an LLC can be about ten times more expensive than forming a corporation. I recently posted an article comparing an s corp to an LLC from the New York perspective: http://ratschko.com/free-legal-information-for-new-york-businesses/new-york-business/choosing-between-an-s-corporation-and-an-llc---the-new-york-perspective.html

posted on Friday, March 16, 2007 at 1:51 PM by Imke Ratschko


Colorado is a very small-business friendly state and LLCs are created with a simple online form and a $25 fee. More info for Colorado readers is at: http://www.sos.state.co.us/biz/FileDoc.do

Main reasons not to go LLC for a startup are if you want different classes of shareholders or have complex investment and distribution needs.

Also note that for US Fed taxes there is not an LLC status (LLCs are state entities) so LLCs could typically file like an s-corp (http://www.irs.gov/businesses/small/article/0,,id=137016,00.html)

posted on Friday, March 16, 2007 at 2:36 PM by Scott Meade


I recently faced this same dilemma. We decided to go with and S Corp over LLC because of tax benefits. With an S Corp the money you make in salary is taxed at your normal rate. With an LLC, you are considered self employed and have to pay a 15% tax rate. If you don't make tons of money overall, you can save with an S Corp. We also incorporated in New Hampshire which has very friendly laws all around. I wrote up our experience as a how to guide here: http://corkboardinc.com/blog/2007/03/12/how-to-create-a-corporation/

posted on Friday, March 16, 2007 at 5:19 PM by Jordan McKible


I don't think there is a double taxation issue with C corporations. The corporation is taxed on the profits (which is income - expense, and expenses include payroll).

posted on Saturday, March 17, 2007 at 3:32 PM by Ajay Dwivedi


Wish I had read this before we determined what to do with nPost.com. We would have saved ourselves a lot of time, fortunately we went with the LLC.

posted on Saturday, March 17, 2007 at 3:35 PM by Nathan Kaiser


One other issue is that some companies won't take your contract unless you're a C Corp. I had to this to do consulting for a power company in the USA.

posted on Saturday, March 17, 2007 at 11:14 PM by Super Mike


In Texas the cost is the same for all three entities.

posted on Saturday, March 17, 2007 at 11:44 PM by codist


One thing to consider with an LLC is its strength as a liability shield. In many states, S-Corps are more tested in this regard. It varies from state-to-state so check with your local small biz development center.

posted on Monday, March 19, 2007 at 2:55 PM by Nathan


hi, Being based in asia, we require input on forming companies solely to get the benefit of payment services like paypal pro and Google checkout which are available only for US companies. So do i need to have a US company registered as a LLC just to get these benefits ? how does it work in terms of taxation? how do you measure icome generated out of US for a web service. (location of paying client?) we are based in asia(hk) and looking to launch our online marketplace shortly. Currently in development atwww.ushops.com/beta.

posted on Wednesday, March 21, 2007 at 5:59 AM by altaf


If you are based in California, the tax treatment of LLC's is unfavorable compared to a sub-S. There is a special tax on the gross income of an LLC and the distributions are treated differently than an S. Also, it takes perhaps 15 minutes a year to handle the board minutes and filings for an early stage S, so please don't pay anyone to do custom minutes etc..Once you file you may get offers in the postal mail from private firms. Ignore them.

posted on Thursday, March 22, 2007 at 3:10 AM by Sean Murphy


@sJ:

I don't believe there are any citizenship requirements to form an LLC -- I'm not a US Citizen (I am a legal permanent resident) and have had no problems in that regard.

@Ajay Dwivedi: Dig around online for a more detailed accounting response, but double taxation is absolutely the curse of a c-corp.

posted on Saturday, March 24, 2007 at 10:28 PM by


ı love you

posted on Sunday, February 10, 2008 at 4:12 PM by murat


* Form 16 is a certificate issued by the employer at the end of the year and provided to the employee. This certificate provides details of the salary income of the employee and the TDS deducted from the employee's income.
* Form 16 is all you need to file ITR if you have reported all your income to your employer.
* It is your right to obtain F16 from the employer within 15 days time after the end of the financial year.
* Obtain your Form 16 early, so that you can file your return early. The earlier you file, the faster you will get refund.
* Your chance of scrutiny reduces by filing early.
* Ensure that you have F16s from all the employers that you have worked for during the year.
taxspanner.com

posted on Monday, April 21, 2008 at 5:09 AM by Tax Spanner


To Ajay re: Double-tax issue of C-corps.
C-corp income is taxed; dividends are NOT EXPENSE ITEMS -they are a distribution of income and are not deductible to derive net taxable income. When a C-corp issues dividends to its shareholders it is a distribution of income that has already been taxed at the corp level. Shareholders receiving those dividend distributions are required to report those dividends on their tax returns as income and pay tax, hence the double-taxation issue. That's why closely-held C-corps will generally try to manage salaries and other benefits/expenses to show little or no income that will need to be taxable to the corp or distributed as 'dividends' to them.

posted on Tuesday, June 10, 2008 at 11:56 AM by Carla, CPA


Is it better to set-up a Delaware or California LLC? And can you recommend a good company that handles the formation and registration of an LLC.

posted on Wednesday, June 25, 2008 at 6:39 PM by Tahir


I LIVE IN NEBRASKA AND I AM PUTTING TOGETHER A AUTOMOTIVE TOWING ETC COMPANY POSSIBLE THERE WILL BE AN INVESTOR OR I MIGHT ROLL THE DICE AND GO SOLO SHOULD I FORM AN LLC OR INC ? I PLAN ON SEEING PROFIT WITHIN FIRST 6MONTHS ANY HELP SUGGESTIONS WOULD BE HELPFUL  
 
 
 
THANKS  
 
-R FROM NEBRASKA

posted on Sunday, December 28, 2008 at 7:13 AM by R-NE


If you file for an LLC in Delaware, are there any additional documents/forms that you need to file to do business in Mass? 
 
Please advice, if you have had any experience with this. 
 
Thanks, 
Bina

posted on Wednesday, February 04, 2009 at 1:29 PM by Bina Shah


how much does allc cost

posted on Tuesday, February 10, 2009 at 1:22 PM by madison


how much does a llc cost

posted on Tuesday, February 10, 2009 at 1:23 PM by madison


It depends on which state you file it in. Delaware is generally where most llc's are filed its about 200$. 
Good luck!

posted on Tuesday, February 10, 2009 at 3:48 PM by Bina


WHAT WOULD BE YOUR ADVICE TO ME IF I'M JUST STARTING A SIDE JOB COMPANY THAT CONSIST OF MAYBE 6PPL MAX. OUR SIDE JOBS INCLUDE FROM JUST CUTTING PALM TREES TO LANDSCAPING (KEEP IN MIND EVERYONE STILL HAS A FULL TIME JOB, THIS IS JUST A SIDE JOB, AFTER WORK OR ON DAYS OFF). SO WHAT DO YOU THINK, INC, LLC OR DON'T NEED ANY? THANK YOU.

posted on Wednesday, July 22, 2009 at 1:17 PM by bell


I am thinking of incorporating. I am wondering if both are considered entities aside from the owner or ceo of the company

posted on Monday, September 14, 2009 at 10:06 AM by Rafael Suarez


#1

posted on Tuesday, September 15, 2009 at 7:24 PM by kristy allen


I am getting ready to start my own business flipping real estate, along with performing other real estate deals. Should I get an LLC?

posted on Friday, September 18, 2009 at 8:48 AM by Country


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