At some point, an entrepreneur is ready to take the concept they have been developing to the next level and start a business, which usually requires forming a business entity. There is often a triggering event – the need to bring in co-founders, investors, partners, customers or to protect intellectual property.
What are the Advantages of Forming a Business Entity for a Tech Startup?
- Protection from Personal Liability. If you conduct business without forming a new legal entity, that is as a sole proprietorship, your personal assets will be liable for the debts of the business. For most, this is a good enough reason on its own to incorporate as the founders do not want personal liability for business debts, including trade debts (vendors) and investment losses.
- Taxes. You should always consult with a tax professional when forming a business. Startups can also sometimes take advantage of special tax incentives:
- You may be able to avoid capital gains tax when you sell your interest in the business if the stock meets the requirements for Qualified Small Business Stock (QSBS).
- You may be able to use the Research & Development (R&D) tax credit as an offset against payroll tax, even if the company is pre-revenue.
What Form Should the Legal Entity Take?
- The choice of legal entities is among a Corporation, Limited Liability Company (LLC), or Partnership.
- Within these, the corporation can be a C Corporation or an S Corporation, and the partnership can be a General Partnership or a Limited Partnership.
- The threshold question is whether the startup plans to take on angel investment, venture capital, or institutional investment. If so, these investors will typically invest only in a C Corporation that is organized in Delaware. It will usually then make sense to form a Delaware C Corporation at the outset.
- Advantages: The corporation is ready to take on investors who will be familiar with Delaware corporate law and it may be possible to use some of the above tax benefits.
- Disadvantages: There are increased fees since you are required to pay fees in both Delaware and the state in which you are conducting business, often the state where the founders are based. Also, a C Corporation has double taxation, once at the corporate level and once at the shareholder level when profits are distributed.
- If the startup does not plan on taking on venture capital and institutional investors, an LLC based in the state in which the founders are located may be the best choice.
- The LLC provides protection from personal liability.
- The LLC is a “pass through entity” so there is only one level of taxation at the ownership level.
- The LLC requires less corporate formality to operate (e.g. no shareholder and board meetings required).
- The LLC can be more closely structured to meet the founders’ requirements (for example customized ownership and profit distribution structures).
- The LLC requires fees only in the state in which it is formed.
- An S Corporation may also be a possibility for startups, which is an election made at formation, that results in basically one level of taxation at the ownership level like an LLC.
If you require any further information about incorporating a startup, please contact Edward Grenville, Managing Shareholder, Inspire Business Law Group, PC (egrenville@inspirelawgroup.com; +415 279 0779; www.inspirelawgroup.com).
This article is provided for educational and informational purposes only and is not intended to be, and should not be construed as, legal advice.