Choosing your company’s legal entity is the first important legal decision you will make for your startup. For many entrepreneurs, this is probably a distant thought.

Although simple from a legal perspective, entrepreneurs screw this up all the time and form the wrong entity (costing about $5000 to fix). But, who has time for this legal stuff or wants to pay a lawyer $300 an hour to answer this simple question? Crickets . . .

Your legal entity choice is predominately dependent upon 3 major questions: 1) how do I protect myself from lawsuits against the company, 2) how will you fund the company, and 3) what entity will give you the best tax benefits?  This varies significantly based on the industry your company plans to operating in.  While this blog post will significantly focus on the technology startup world we plan to expand this reasoning and applicability to other industries and geographic locations . . . so stay tuned.

The three major legal entities in the technology startup space are the Delaware Corporation (“DE Corp”), the Corporation in your company’s home state with an S-Corp election with the IRS (S-Corp) and the Limited Liability Company (“LLC”) in your company’s home state. They are each discussed in greater detail below accompanied by great insights from some of the best startup and small business attorneys in Silicon Valley and other tech hubs.  Because of the legal and tax implications, make sure to run any decisions by your legal and tax professional.

1.   Delaware Corporation 

2.  Corporation In Home State With S Election

  • What is it?  Entities which have a corporation structure but have elected to report their flow-through income and losses on their personal tax returns with the IRS. This allows S corporations to avoid double taxation on the corporate income.  There can be significant tax saves when forming as a S-Corp if it is done correctly, but there are a number of qualifications to be an S-Corp.  S-Corps can still have employee stock plans just like a corporation.
  • When to use? There are a number of situations where an S-Corp makes sense. – you should have this discussion with your tax professional.  A number of tax professionals agree that single person independent contractors and some small closely held organizations (like tech outsourcing groups) should always form as S-Corps because of the potential tax savings.   You should consult your tax advisor to make sure you business model will reap the highest tax savings under an S-Corp. Sometimes, Delaware Corporations who do not plan to raise VC money until after they are making revenue, will temporarily elect to be an S-Corp to reap the tax benefits and then will un-elect immediately prior to raising VC money (it is very easy to un-elect).

3.  LLC

  • What is it? They were intended to serve as an alternative to partnerships – to provide the “corporate” vail to partners.  Because of their ease of formation, many online companies have pushed LLCs for the decade.  LLCs can opt to be taxed in a as a corporation or S-corporation.
  • When to use? In certain partnership arrangements, when there is no need to have outside investors, no need for an employee stock plan and under certain business models an LLC will make sense.  Again, you should consult your tax professional for a precise evaluation of these factors.
  • What to do? Guide to Forming a LLC (Coming Soon!)

DISCLAIMER

The contents of this page is not legal advice and is not a substitute for professional legal advice. Under no circumstances does the content contained herein create an attorney-client relationship nor is it a solicitation to offer legal advice. If you ignore this warning and convey confidential information in a private message or comment, there is no duty to keep that information confidential or forego representation adverse to your interests. Seek the advice of a licensed attorney in the proper jurisdiction before taking any action that may affect your rights.

About Author Matt Faustman


Matt is the co-founder and CEO at UpCounsel. Matt believes in the power of online platforms to change antiquated ways of life and founded UpCounsel to make legal services efficiently accessible. He is responsible for our overall vision and growth of the UpCounsel platform. Before founding UpCounsel, Matt practiced as a startup and business attorney.

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