Choosing the Right Entity: What Every Founder Needs to Know
One of the most common questions of first-time founders is: what type of business entity should I form? The corporate structure you choose can affect everything from your taxes to your ability to raise funds, so it’s worth getting it right from the start. Whether you’re eyeing an LLC or a corporation, here’s what you need to know to set your company up for success.
Corporation or LLC? Breaking Down the Basics
For most founders, the decision boils down to two options: a corporation or a limited liability company (LLC). Each has its pros and cons; the right choice depends on your business goals, your investors, and your long-term exit strategy.
Corporations are a favorite for high-growth startups looking to raise venture capital. They offer legal certainty and a more standardized structure more established framework, which makes them appealing to investors. With a corporation, you’ll typically deal with a few key documents like articles of incorporation, bylaws, and various shareholder agreements. These documents ensure everyone’s rights are clearly defined and provide a predictable governance structure.
LLCs, on the other hand, offer more flexibility and are often a better fit for businesses run by a single individual or a small group of people who don’t expect to seek outside investment anytime soon. They’re also popular for companies that will hold real estate they’re frequently used for companies holding real estate, where the goal isn’t to accumulate outside capital but to manage and protect assets.
Corporations Provide Legal Certainty
One of the biggest advantages of a corporation is the legal certainty it provides. Corporations are governed by well-established corporate law, with clear guidelines for everything from governance to investor rights. This is one reason why VCs and institutional investors prefer them—they know exactly what they’re getting into.
Corporations also allow investment from a broader range of investors. Many investment funds will not invest in LLCs. So if raising institutional capital is part of your growth plan, a corporation is usually the way to go.
And then there’s Delaware. The state’s business-friendly corporate laws have given it an early lead, and today, Delaware is home to most ofUS corporations. What makes Delaware special? It comes down to the rich body of business law built from years of complex cases, which provides predictability for businesses. That predictability is particularly valuable to professional investors who may sit on the board of directors of several companies and want to streamline their SOPs and diligence processes. This predictability is particularly valuable to investors who need to assess and compare multiple investment opportunities.
That said, Delaware isn’t always the right move. One downside is the need for dual registration if your company operates in another state, meaning you’ll be paying both Delaware’s franchise tax and your home state’s fees.
Corporations vs. LLC
What About LLCs? Flexibility and Simplicity
Where corporations offer structure and predictability, LLCs offer increased flexibility. Unlike corporations, LLCs aren’t required to follow a rigid governance structure. There’s no need for bylaws, board meetings, or shareholder agreements—unless you want them. Instead, LLCs are typically governed by an operating agreement, which can be as simple or complex as you need.
LLCs also offer flow-trough taxation, which means profits and losses go straight to the owners’ personal tax returns, bypassing corporate taxes. This can be a huge tax advantage for small businesses or companies that don’t need to retain earnings for future growth.
However, if you’re looking to accumulate capital or reinvest profits in the business, a corporation might be better suited. Corporations can retain earnings, whereas LLC owners may be taxed on profits even if they leave them in the business.
Tax Considerations: What to Keep in Mind
Taxes are where things get interesting—and complicated. Corporations face two-tier taxation, meaning the company pays taxes on its profits, and then shareholders are taxed again on any dividends. For high-growth startups that plan to plow earnings back into the company, this may not be a huge concern early on. But it’s worth considering as your company matures.
For smaller businesses, especially those run by a single person or a tight-knit group, LLCs often win on tax flexibility. With flow-through taxation, you’re taxed only once on the income. Plus, LLCs allow for special allocations of profits and losses, which means you can distribute profits in a way that doesn’t strictly follow ownership percentages. This can be useful for founders who want to reward certain members of the team or investors.
But there’s a catch—if you’re an active owner in an LLC, you’ll likely owe self-employment taxes on your share of the profits. For many founders, this can be an unwelcome surprise when tax season rolls around.
S Corporations: A Hybrid Approach
If you’re torn between the simplicity of an LLC and the structure of a corporation, an S corporation might be a good middle ground. S corps combine the pass-through taxation of an LLC with the legal structure of a corporation. But there are some restrictions—you can only have up to 100 shareholders, and all shareholders must be U.S. citizens or residents. S corps also avoid double taxation, but you’ll need to follow more rigid governance rules than an LLC.
The downside? S corps don’t offer the same flexibility as an LLC when it comes to ownership structures or special allocations of profits. If you’re planning to seek venture capital or attract a large group of investors, a traditional C corp is probably still your best bet.
Asset Sales and Entity Conversions
Another factor to consider is the tax treatment of asset sales. If your company is likely to sell its assets down the road, an LLC may offer more favorable tax treatment since the gains from the sale can be passed through to the owners. With a corporation, you’re more likely to face double taxation on the sale of assets.
If you start as an LLC and later decide you need the structure of a corporation, you can always go through an entity conversion. While converting from an LLC to a corporation is fairly common, it does come with costs and potential tax implications. So it’s worth weighing the pros and cons of starting as an LLC if you think you may eventually need the flexibility of a corporation.
Nevada & Wyoming: Other Popular Options
Delaware may dominate, but Nevada and Wyoming have also carved out niches as business-friendly states. Both states boast low or no corporate income taxes and offer similar protections to Delaware. Wyoming, in particular, is gaining traction with startups because of its low fees and strong privacy protections for business owners.
However, just like Delaware, if your business operates in another state, you’ll need to register there as well, which can diminish some of the benefits. Always consider where your business will actually operate before deciding to form in another state.
The Bottom Line: Know Your Goals, Plan for Growth
When choosing between an LLC and a corporation, there’s no one-size-fits-all answer. The right entity for your business depends on your goals, your plans for growth, and how you want to manage taxation and governance. If you’re planning to raise capital from institutional investors or accumulate retained earnings, a corporation might be your best bet. But if flexibility and tax simplicity are higher priorities—especially in the early stages—an LLC could serve you well.
Whatever you choose, make sure you understand the legal and tax implications and stay nimble. After all, no decision is permanent, and your needs may change as your company grows.