Selecting the appropriate corporate form is a pivotal decision for founders embarking on their entrepreneurial journey. Your choice can significantly impact your startup’s structure, taxation, liability, and (most importantly) ability to attract investors. It’s not a one-size-fits-all scenario; instead, it’s a decision that should be carefully tailored to your specific business goals, ownership structure, and long-term vision. In this guide, we will explore the various corporate forms available to founders – from Limited Liability Companies (LLCs) to C Corporations (C Corps) and S Corporations (S Corps) – shedding light on their unique characteristics, tax implications, and suitability for different entrepreneurial ventures. We will explain why one of these is generally the right solution for founders seeking venture capital funding.
Types of corporate forms
Indeed, let’s break down the main types of corporate forms – Limited Liability Company (LLC), C Corporation (C Corp), and S Corporation (S Corp) – highlighting their differences, particularly in terms of tax treatment:
Limited Liability Company (LLC)
- Structure: Flexible and relatively easy to set up, combining elements of a partnership and a corporation.
- Ownership: Owners are called members, and there is no restriction on the number or type of owners.
- Limited Liability: Members are generally not personally liable for the company’s debts or liabilities.
- Tax Treatment: LLCs are typically treated as pass-through entities for tax purposes. Profits and losses flow through to the individual members’ tax returns, avoiding double taxation.
C Corporation (C Corp)
- Structure: Independent legal entity with stockholders, directors, and officers.
- Ownership: No restrictions on the number or type of stockholders, allowing for broad ownership.
- Limited Liability: Stockholders enjoy limited liability; personal assets are protected from corporate debts.
- Tax Treatment: C Corps face double taxation. The corporation itself is taxed on its profits, and stockholders are taxed on dividends received. However, it also benefits from a Qualified Small Business Stock (QSBS) treatment upon exit.
S Corporation (S Corp)
- Structure: Similar to C Corps but with certain IRS restrictions on ownership and structure.
- Ownership: Limited to 100 stockholders, who must by U.S. citizens or residents, and the entity cannot have multiple classes of stock.
- Limited Liability: Stockholders enjoy limited liability.
- Tax Treatment: S Corps are pass-through entities similar to LLCs. Profits and losses pass through to the individual stockholders’ tax returns, avoiding double taxation. However, S Corps must allocate profits and losses according to the percentage of ownership.
A C Corp provides founders with substantial tax advantages on exit
One compelling reason for startups to consider choosing C Corporation status lies in the potential tax advantages afforded to founders through the Qualified Small Business Stock (QSBS) treatment. QSBS is a tax provision designed to encourage investment in small businesses by offering significant tax benefits to eligible stockholders. For founders of C Corporations, meeting specific criteria (that most tech-based startups satisfy) can result in a substantial reduction in the capital gains tax on the sale of their stock. Under QSBS, if a founder holds qualified stock for at least five years, they may be eligible to exclude up to $10 million or ten times their basis in the stock, whichever is greater, from federal capital gains tax. This exclusion can translate into a considerably higher take-home income following a successful exit. To illustrate, consider a hypothetical exit where a founder’s eligible gains are $15 million. Without QSBS, the founder would face a marginal federal capital gains tax rate of about 23.8% or roughly $3.5 million. With QSBS, the first $10 million in capital gains is under $1.2 million. The QSBS saved the founder approximately $2.3 million in taxes.
Finally, while the double taxation for C Corps may be onerous in theory, for VC-backed companies, this is typically not an issue as they are years or even decades away from being profitable. Typically, founders and investors are rewarded upon exit, not for producing a profit stream but from a financially remunerative acquisition, and that is where the C Corp shines.
Venture Capital only invests in C Corps
Venture capital (VC) investors overwhelmingly prefer to invest in C Corporations due to this legal entity’s unique structure and advantages. C Corporations provide a robust framework for venture-backed startups, offering unlimited potential for growth and scalability. Unlike other structures, C Corps allow for a diverse and large number of stockholders, making it an ideal vehicle for attracting multiple rounds of funding. Additionally, C Corps facilitates the issuance of different classes of stock, enabling sophisticated equity structures that align with the preferences of various stakeholders. Finally, many VCs have specific covenants written into their agreements with investors requiring they only invest in C Corps, meaning they would have to turn down any opportunity that was not a C Corp.
In this article, we explored the three primary corporate forms – Limited Liability Company (LLC), C Corporation (C Corp), and S Corporation (S Corp) – and highlighted their fundamental differences, particularly in terms of tax treatment. We discussed how LLCs and S Corps offer pass-through taxation, while C Corps theoretically face potential double taxation but provide founders with the Qualified Small Business Stock (QSBS) advantage. QSBS can significantly reduce capital gains tax for founders who meet specific criteria and hold stock in a C Corp for at least five years. Furthermore, we explained why venture capital (VC) investors predominantly invest in C Corporations. C Corps’ structure, scalability, and favorable tax treatment for investors, along with potential QSBS benefits for founders, make them the preferred choice for VC-backed startups seeking high-growth opportunities.