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.