Now that you have decided to start a company, the first decision you will make as an entrepreneur is the form of business entity to select. As a practical matter, you have three likely choices: a C corporation, an S corporation and an LLC. Unfortunately, there is no one size fits all solution or a single right answer.  The answer to which type of entity to choose is it depends.

As background, all three types of entities, if properly formed and maintained, will provide a measure of liability protection so that if the business fails, you will not have personal liability to creditors (with some notable exceptions). That is where the similarity ends.

A corporation taxed under Subchapter C of the Code[1] is often called a C corporation for short. This is another way of saying that the corporation has not elected the special tax regime under Subchapter S of the Code, as discussed below. The distinguishing tax feature of a C corporation is that it is a separate tax paying entity. The C corporation pays corporate tax on its earnings. If the corporation then distributes those earnings to its owners (also called shareholders), the shareholders are again taxed (albeit at a lower rate for most dividends from domestic corporations). This is what is meant by the term double taxation that accountants and lawyers regularly use. To avoid this double taxation, corporations will attempt to distribute as much of its earnings as they can in the form of deductible payments, such as compensation.  That compensation, however, will be taxable at a rate potentially higher than the dividends would have, and will also attract employment taxes including FICA and FUTA.

If double taxation is the bad news; the good news is that the federal corporate tax rate on C corporations is a flat 21% – the lowest it has been in many years – as opposed to individual tax rates that can be as high as 37% federal (plus state). Importantly, gain from the sale of stock issued by some C corporations can qualify for an exclusion from federal tax as qualified small busines stock. Most venture backed and public companies are C corporations.

Corporations are generally managed by a board of directors, who are periodically elected by its shareholders. The corporation’s rules are set forth in its bylaws. Much of corporate governance is prescribed by law.

A state law corporation (or other qualifying entity) that elects to be taxed under Subchapter S of the Code is called an S corporation. Unlike a C corporation, an S corporation is not generally a separate taxpayer entity. Instead., its earnings pass through and are taxed to the owners (shareholders) pro rata based on share ownership. Thus, S corporations are sometimes grouped with partnerships as passthrough entities. S corporations differ however, from partnerships in that the owners can potentially avoid self-employment taxes on the income of the S corporation. Largely for that reason, many closely held small businesses (and some large ones) elect to be taxed as S corporations. Even Joe Biden famously runs his business income through an S corporation.

A limited liability company, or LLC, is a creature of state law that offers limited liability to all its members but is taxed as a partnership or passthrough, unless otherwise elected. As a partnership, its income passes through to its owners (or interest holders or members) similar to the way an S corporation is taxed. Certain types of S corporation income and LLC income can qualify for a special 20% qualified business income deduction.[2]  Unlike an S corporation, however, appreciated assets can be distributed from an LLC tax free. LLCs are governed by an operating agreement, and usually managed by one or more managers. LLCs are used in businesses that hold appreciating assets such as real estate and securities and businesses in which the members want passthrough treatment. Also, unlike an S corporation, the income of an LLC will be subject to self employment taxes.

This short summary illustrates that choice of entity can be a complex decision. The corporate and tax distinctions between the various types of entities could fill a book, but the new entrepreneuer need not get so involved in the details to decide. As mentioned above, most VC backed companies are C corporations. Thus, as a general rule, a Silicon Valley startup that must raise venture capital to succeed will almost always organize itself as a C corporation. I call these go-big-or-go-home-companies, and they should usually be C corporations. On the other end of the spectrum, the closely held company that will never get near a VC but will throw off many years of a modest but steady annual income will want to consider being an S corporation for the self employment tax savings. I call these life style companies.

The decision becomes more difficult for companies caught in the middle. They could be a candidate for venture, and could be scalable and then exit (advantage C corporation) or they could spend many years earning a small enough profit to make self employment tax savings meaningful. What should a company do if it is caught in the never never land of maybe financeable?

The LLC can be a good vehicle to bridge the gap between a life style company and a go-big-or-go-home-company. As an example, a company can start its life as an LLC electing to be taxed as a partnership or an S corporation. If it does not attract venture, it has a tax efficient passthrough structure that can easily be converted to an S corporation, if desired. If it does attract venture, it can easily convert to a C corporation to close its deal. It is not a perfect solution as there will likely be some loss of QSBS benefit, and there are complex tax rules that may apply to incorporating an LLC, especially if it has debt financed losses. There is also the fact that he entrepreneur may have paid for two entities: an LLC and a C corporation. That is the price of delaying a decision, and seeing the next card before placing your bet.

Choice of entity is often a difficult decision, but there is a strategy for finding the optimal solution.

DISCLAIMER: This article does not, and is not intended to, constitute legal advice; instead, all information and content is for general informational purposes only.  Readers should contact their own attorney to obtain advice regarding any particular legal matter as legal advice is very fact specific.  No reader site should act or not act based on this article without first seeking legal advice from counsel in the relevant jurisdiction.  Access to this article does not create an attorney-client relationship between the reader and the author  or his law firm.

[1] Internal Code of 1986, as amended.

[2] Code section 199A.