HOW TO: Legally Structure your Startup

Whether you’re the next big thing in social gaming or organic knitwear, each startup eventually faces the same gnawing questions: How should I legally structure my business? Should I form an LLC or an S-Corp? What about an S-Corp vs. a C-Corp?

These questions are only natural. After all, the legal and financial ramifications are significant. And your passion might be designing iPhone apps or analyzing Twitter data, but I’m pretty confident it’s not tax law.

While circumstances vary among individuals and individual businesses, here are some general guidelines to help you jump-start your decision on business structures. There are other possible business types, but I’ll focus on three: the LLC, the S Corporation, and the C Corporation.

The LLC (Limited Liability Company)   The LLC is very hot among startups now. Owners of an LLC jointly own and manage the business, and share in the profits. Like a corporation, the LLC is a separate legal entity — it can sue and be sued, it can own property, but individual owners are shielded from personal liability. The LLC (like the S-Corp and C-Corp) gives you peace of mind that your personal property can’t be wiped out because an unsatisfied client sues your company, or if your business runs into financial trouble because a key customer fails to pay. However, it is important to note that an LLC is not an ironclad protection against personal liability, as courts around the country have begun to override the LLC if there has been fraud or misrepresentation.

The LLC is ideal for startups that don’t want or need much formality, but still want legal protection. In a corporation, minutes must be filed and resolutions passed whenever you want to make changes to the company. In the LLC, this isn’t the case. LLCs just use an informal “operating agreement.” Depending on your particular type of business, this could either be a great time and money saver, or the gateway to conflict down the road.

An LLC is considered a pass-through entity when it comes to federal income tax. This means the business itself is not taxed; rather, any business income or loss is reported on each individual owner’s tax return. However, every business has different financials, so please remember that it’s wise to consult with a tax advisor on your own situation.

In an LLC, income and loss can be allocated disproportionately among the owners; in the S-Corp, income and loss are assigned to each shareholder strictly based on their pro-rata share of ownership.

So, if I own 80% of an LLC, my share of the tax burden doesn’t necessarily have to be 80% of the taxable income. But if I own 80% of an S-Corp and that company makes $100,000 in taxable income, I will be taxed on $80,000 of income, even if I never withdrew a cent from the corporate bank account.

The S-Corp   An S-Corp typically starts off as a regular C Corporation, and then soon after (or to get technical, within two months and 15 days), all shareholders must submit Form 2553 to the IRS. This means the company is now treated as a pass-through entity, similar to the LLC, and income/loss is passed through to each shareholder’s individual tax statement.

An S Corporation should be selected when your startup will make a profit soon after incorporation —- and most of that profit will be distributed to shareholders as a dividend. If your business model requires you to reinvest the profit back into the company for growth, you should be looking at a C-Corp instead. This is due to the simple fact that all shareholders will still be taxed on the profits individually, even though those profits are pumped back into the business, instead of into shareholders’ wallets.

Beyond tax matters, there are other rules shaping whether the S-Corp is right for your startup. An S-Corp cannot have more than 100 shareholders. All shareholders must be individuals (not LLCs or partnerships) and legal residents of the United States.

The C-Corp   That brings me to the C Corporation. Unlike all other forms of business, a C-Corp is not a pass-through entity. It’s taxed separately and the company must file its own tax returns with Form 1120. C-Corps have their own tax brackets, which in many cases, are lower than individual tax rates.

Unlike the S-Corp, almost anyone can own shares in a C-Corp and there’s no limit on the number of shareholders. Obviously, if you anticipate having more than 100 shareholders, the C-Corp is the way to go. In addition, the C-Corp lets you create different classes of stock, so owners can have different shares in terms of profits and losses.

With a C-Corp, individuals are taxed only on the money they receive. Therefore, if you’re planning on reinvesting your startup’s profits back into the company, a C-Corp is preferred since these profits are usually taxed at a lower rate. Additionally, the C-Corp is generally the preferred business structure for startups seeking funding from different sources, including VC and equity financing.

Keep this information in your back pocket as you get the ball rolling on your business venture, and always be sure to consult a lawyer and/or tax advisor before making any firm decisions. Good luck!