What about LLCs?
LLC stands for limited liability company. LLCs are a popular choice for regular small businesses because they allow for pass-through taxation, offer limited liability, and are perceived as being simple and cost-efficient to operate.
While LLCs are popular for regular small businesses, including internet and software-related small businesses, they typically aren't appropriate for startups. Startups and regular small businesses are very different from each other when it comes to what legal paperwork is appropriate.
Even so, you might see some resources recommending LLCs for startups. That's often because many people use the term startup to refer to any small business, as opposed to one that's designed to grow fast. Regular small businesses also outnumber startups by several orders of magnitude, which leads to a lot more content about forming LLCs. But startups and regular small businesses have different needs. Most startup attorneys view corporations, not LLCs, as the best choice for startups.
LLCs aren't corporations, so it's incorrect to refer to the formation of an LLC as an incorporation.
As noted in Audience, the information in this handbook is written for startup founders based in the U.S. If you're based elsewhere and are forming a U.S. entity as a parent or subsidiary of a local entity, it's possible that some startup attorneys might recommend an LLC in some scenarios.
Some people recommend LLCs instead of corporations for tax reasons. However, for the vast majority of startups, the theoretical tax benefits never materialize. On top of that, only corporations can get the benefits of qualified small business stock (QSBS), which can result in very significant tax savings.
One concern people have with corporations is double taxation. Double taxation refers to taxes being paid twice on the same income. With corporations, this can happen when profit is taxed when a corporation receives it, and then is taxed again when the corporation distributes it to shareholders.1 LLCs, by contrast, can have pass-through taxation, which enables the profit to be taxed at the individual level only.
This usually isn't much of a concern for startups because most early-stage startups aren't distributing profits (i.e. issuing dividends). They're reinvesting profits into the business, since they're optimizing for growth. And when a corporation pays salaries to its founders, those are deductible business expenses, so there isn't any double-taxation there.
What if I want my startup to become profitable as soon as possible? In that case, should my startup form as an LLC?
Perhaps counterintuitively, whether a startup chooses to focus on profitability or hypergrowth doesn't typically affect whether it should form as a corporation or LLC. Profitable startups still reinvest the profits into the business in order to optimize for growth. In that scenario, double-taxation doesn't occur because the startup isn't distributing profits to owners, even though it's considered profitable.
If you have a business that decides to distribute profits to owners, that business is typically considered more of a regular small business than a startup. It often makes sense for regular small businesses to form as LLCs in order to avoid double taxation.
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Some advisors point out that "double taxation" can be a misnomer because the tax rates for corporate income are often lower than they are for individual income.
One of the benefits of LLCs is pass-through losses. This means that if the LLC has losses, they can be passed through to its members, who can then deduct the losses from their personal income for tax purposes. Most startups lose money in the early days, so being able to pass through losses sounds great in principle. However, what many people don't realize is that the amount a founder can pass through is typically limited to what they contributed to the startup at formation, which is typically very little (often around $100 or less). So in practice, the ability to pass through losses usually isn't meaningful.
QSBS stands for qualified small business stock. QSBS can provide significant tax benefits for corporations and is not available for LLCs.2 With QSBS, stockholders who hold on to their shares for at least five years might be able to exclude up to $10 million in gains from federal taxation when they eventually sell their shares in an acquisition, IPO, or secondary transaction. In some states, QSBS can provide similar benefits for state income taxes as well.
Even though the "SB" in "QSBS" stands for "small business", startups can take advantage of QSBS tax treatment.
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If an LLC converts to a corporation, it's possible in some rare circumstances for the resulting stockholders to exclude even more than $10 million in gains. However, this also comes with a significant risk of stockholders paying more in taxes than they would have had the startup incorporated as a corporation in the first place. In addition, the five-year holding period typically only starts at the time of the conversion. As a result, it's uncommon for startup attorneys to advise a startup to form as an LLC with the intent of converting to a corporation later for a larger QSBS exemption.
Some people think LLCs are preferable because they don't need to pay franchise taxes, while corporations do. At least in Delaware, where the vast majority of startups are incorporated, this isn't true. Both Delaware LLCs and corporations need to pay franchise taxes, although LLCs pay $150 less per year, at minimum.
Flexibility / Customizability
Some advisors say that LLCs are a more flexible and customizable business structure than corporations. This is true, in a sense. But these characteristics are usually irrelevant for most startups and can even be harmful.
LLCs are considered more customizable because the law doesn't give as much guidance on how they operate, compared to corporations. Instead, the way an LLC operates is governed by agreements between its members, which allows for substantial flexibility.
This flexibility is usually unnecessary for startups, though. Compared to regular small businesses, startups tend to be more similar to each other in terms of how they operate. So there's generally less need for customization with a startup than there might be for a regular small business. The standardized paperwork for forming startups as corporations is typically flexible enough to handle any necessary customizations.
Not only is the flexibility usually unnecessary, but it can also increase the chance of problems. You can think of legal paperwork as a set of instructions for how people should behave. Just like source code for computers, you need to test legal paperwork in order to find problems and fix them. As a result, legal paperwork that takes an approach refined over decades is going to generally be less likely to have issues than legal paperwork drafted from scratch yesterday. Investors also often dislike legal paperwork that's heavily customized, in part because it increases the chance they will misunderstand how things work.
Ease and Cost of Operation
Some people say that LLCs are cheaper and easier to maintain. This can be true in some contexts, but is typically not the case for startups. The reason why some people say LLCs are cheaper to form and maintain is because they have a simpler default structure than corporations, so less paperwork is involved. If all of the paperwork was being drafted from scratch, it would be more expensive to form and maintain a corporation.
The legal ecosystem around startups is very well developed though, to the point where the paperwork for forming and maintaining a startup has largely been standardized. This is not the case for LLC paperwork for startups. So in practice, assuming the same level of legal quality, forming and maintaining a corporation often isn't more expensive than forming an LLC because corporations can leverage standardized paperwork more.
Some people point out that in Delaware, LLCs don't need to file an annual report like corporations do. This is true, although filing the annual report usually takes less than ten minutes a year.
Corporations are more complicated because they require a board of directors.
Most startups just have founders on the board to start. While having a board of directors may seem to introduce complexity, the effect it has on a startup's operations is usually negligible in practice.
Corporations have more overhead because they're required to have annual board and stockholder meetings.
While it's true that annual meetings are a corporate requirement, they are a non-issue in reality because there is usually little consequence for corporations that don't end up holding them.3 It's uncommon for early-stage startups to have annual meetings, even though the vast majority of them are Delaware corporations.
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In theory, not having an annual meeting could be considered a failure to observe corporate formalities, which is one of the factors Delaware courts use to determine whether to pierce the corporate veil. However, under Delaware case law, it's extremely unlikely that failure to hold the meetings alone would play a significant factor in determining whether the corporate veil should be pierced.
Equity Compensation
A popular reason for incorporating a corporation rather than forming an LLC is equity compensation (e.g. restricted stock or stock options). Some people say equity compensation isn't possible with an LLC. While it works differently than with a corporation, there are ways to compensate employees of an LLC by giving them an interest in the business. That said, there is far less standardization around how this works, which means it will typically require more legal fees to implement. In addition, employees may find it confusing since it will be different from how most startups do equity compensation.
Possibility of Conversion
You might not be sure whether your business will be a startup or regular small business. In these cases, some advisors suggest forming an LLC to start. The idea is that founders can convert the LLC to a corporation later if they decide their business should be a startup. Part of the logic behind this advice is a belief that LLCs are simpler and cheaper to form. However, that may be based on outdated information.
In addition, while converting an LLC to a corporation is often simple and straightforward, sometimes it unexpectedly isn't. Though uncommon, some end up taking months and many tens of thousands of dollars in legal fees. Unfortunately, this is likely to happen at a very inconvenient time, when the conversion is being done in order to receive funds from investors.
It's worth mentioning that corporations can convert to LLCs, much like how LLCs can convert to corporations. There's a larger chance of negative tax consequences from converting a corporation to an LLC, but this depends in part on how much the business is worth. If you're making the choice to run your company as a regular small business instead of a startup, there's a greater chance that the business isn't worth a lot at that moment. In that case, converting your corporation to an LLC might have fewer negative tax consequences. Compared to converting an LLC to a corporation, there's a lower likelihood that there will be an urgent existential situation triggering the conversion.
If you incorporate a corporation and later decide to run it as a regular small business instead of a startup, you could also consider having the corporation elect for pass-through taxation as an S corporation. Startups almost never elect for S corporation status because the ongoing requirements are typically incompatible with raising money. But if you've decided the business will be a regular small business instead of a startup, that may not matter.
In summary, there is no widespread consensus amongst startup attorneys over whether a founder who is unsure whether they are starting a startup or a small business should form a corporation or LLC.
One balanced approach may be to base the decision on what approach you will default to at the beginning. In other words, if you intend to operate the business as a startup by default and running it as a regular small business is more of an optional back-up plan, you may consider incorporating a corporation. In that situation, forming as an LLC could be a premature optimization that you'll never see the benefits of. On the other hand, if you intend to default to running the business as a regular small business and would only run it as a startup in some unlikely fortuitous scenarios, then forming as an LLC may be a better option.
Investor Preference
Many startup investors4 won't invest in LLCs at all.5 There are tax implications that often deter investors from investing in LLCs. Startup investors are also often more familiar with corporations and corporate law, and feel more comfortable investing in them as a result. This is in part due to most startups being corporations, and in part due to the fact that LLCs are more customizable and thus vary more. Finally, startups will need to convert to a corporation in order to do an IPO, and many startup investors are investing only in companies they think may IPO.
