It is difficult to think about incorporating your company when you are trying to actualize a groundbreaking new app. But incorporate you must.
You must take the time to formally organize your venture to better understand who is on your team and in what capacity, and how to attract investors. If you do not, you could be sabotaging a perfectly good business idea before it even gets off the ground. So will you choose to organize as an an LLC or a C Corporation?
If you organize as an LLC:
- You will create your own, custom tailored operation and governance rules.
- You will likely pay lower taxes.
- You will enjoy additional tax benefits if you sell your business.
If you organize as a C Corporation:
- You will attract angel investors and venture capitalist (which hate LLCs).
- You will save the expense of hiring an in-house tax attorney.
- You will have the state of Delaware to make sure your securities law is modern and tailored to protect you and your company.
There are a lot of issues to consider, but you have to organize your venture quickly. There are serious drawbacks to waiting to form your LLC or C Corporation. Doing nothing will land you in a sole proprietorship or a partnership without any protections to limit your personal liability.
Moreover, when you incorporate late, there can be no transfer of the personal and contractual obligations that were made. In other words, you and your partners will forever be personally liable for the contracts you entered into before incorporation. This is very, very bad. Also, backtracking often opens a pandora’s box of complicated legal issues that end up being more expensive in the long run.
Most importantly, when roles are not defined from the very beginning of a venture, infighting amongst founders leads to bad blood and impasses that have been known to drive startups to dissolution. When you define interests and formal roles while organizing into an LLC or C Corporation at the very start, everyone on your team will be on the same page and that is always a good thing.
The above reason not to wait to organize your venture is also a good reason not to use “on the cheap” services like Legal Zoom. Only attorneys can draft buy/sell and other impasse provisions, arbitration provisions, and tie breakers that can set the tone and avoid internal power struggles often seen in startups.
So now that you know that you should act quickly to structure your company… should you choose to be an LLC or a C Corporation? This is a close call. Currently, attorneys see a trend of tech startups being split down the middle on the issue.
The major upside to choosing the LLC structure is the fact that it is not taxed as heavily as a corporation. The IRS categorizes the LLC as a “pass-through” entity that does not pay state and federal taxes. LLCs enjoy the status of a “pass-through” entity like sole enterprises and partnerships, but also enjoy limited liability like a C Corporation. So with the LLC, you get the best of both worlds.
In an LLC, owners simply report their earnings information on personal tax returns.
LLCs pay no federal and state taxes, but some cities impose an annual tax on LLCs. For example, the New York City Unincorporated Business Tax is 4% of all taxable income for LLCs that transact any type of business in the city- even if they are incorporated elsewhere. LLCs also enjoy substantial tax benefits that are not enjoyed by corporations when you decide to sell your business.
Another upside of the LLC is its flexibility when it comes to operation and management. In contrast, C Corporations have rigid and potentially time-wasting formalities for appointing and calling meetings for board of directors and officers. Minutes must be taken, notice must be mailed, and formal votes must be cast. For tech startups, this process can seem archaic and is one of the major reasons why they choose to be an LLC.
Since anyone can manage an LLC, they often custom tailor their own governance rules. The drawback though is that tailoring company-specific solutions can bog down startups since attention and funds must be diverted to craft this legal solution. Another drawback is the generally accepted idea that you need your own tax attorney to navigate the requirements of a unique company structure.
Also, LLCs can repel venture capitalists and angel investors who prefer C Corporations which have a standard preferred stock structure guaranteeing VIP treatment when dividends are paid. And while an LLC can draw up similar rules for a preferred stock structure, it is expensive, complicated, and generally inadvisable.
THE C CORPORATION
As already discussed, the C Corporation is subject to state and federal taxes unlike the LLC. There are other drawbacks to the C Corporation, including various legal compliance requirements that prevent the “piercing of the corporate veil.” C Corporations must prevent courts from piercing the veil that protects the personal funds of officers and directors. By complying, the corporation shows that it is not simply a front and deserves the right to enjoy limited liability.
Most of the benefits to having as a C Corporation only exist if you incorporate in Delaware, which has become the mecca of corporate law and adjudication. Because of the steady stream of income that the state derives from the corporate franchise tax, Delaware operates intelligently and efficiently when it comes the filing of legal documents and the modernization of statutes and laws.
Delaware even has specialized Chancery Courts for tech startups that understand the challenges and impediments to growth that are unique to the trade. Finally, the most important reason why Delaware is favored for incorporation is because it offers the greatest protection to corporate officers and directors from personal liability.
But what is the problem with incorporating in other states like New York and California? Venture capitalists and angel investors do not favor incorporating elsewhere because their laws are quirky and behind the technological times. Attorneys on both sides of that table are looking for predictable intelligent legal judgments, which you only really find in Delaware.
Because C Corporations have complicated securities laws, you need a specialized attorney. One example of the way companies get into trouble when they don’t have specialized attorney is by failing to register all offers for the sale of security. Failure to comply can result in what is called an illegal issuance, which is expensive and drives venture capitalists away.
Another example that demonstrates the need for a specialized attorney involves the unique exemptions for startups that exists in the Delaware securities laws that you would never know existed on your own. Securities law compliance is a veritable landmine of fees and risk these days, so meaningful representation can save you a lot of unnecessary frustration.
So you must incorporate as a C Corporation or form a Limited Liability Corporation (LLC) quickly with the help of a startup attorney. That’s the general consensus of the experts who have seen it all. And depending on your company and your vision, your attorney can help you to find tax and fee exemptions and protect you from costly mistakes made by your startup predecessors.