So, finally, we reach the question I get the most often from new business owners: how should I incorporate? My general answer at the beginning is, you probably don’t need to because you should test out whether your idea has legs.
But once your side hustle has some customers and you know you want to stick with it, it’s likely time to level up to incorporation. A shortcut to this week’s emails: risk, taxes, LLC, S-corp, C-corp.
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In general, there are two considerations for corporation formation: risk and taxes.
Risk: An LLC, S-corp, or C-corp will all limit your personal liability. In other words, your personal assets are separated from the company’s losses or a negative outcome of a lawsuit. If risk to your personal assets like your house and 401(k) keeps you up at night, this is a good enough reason to invest in an LLC.
Taxes: Businesses and people are taxed at different rates by the IRS. At the federal level, businesses are taxed on their profits ONLY, meaning that wages, office supplies, travel, medical insurance, internet, etc., get paid with pre-tax dollars. That’s another 12 to 37 cents you get to spend out of every dollar. It adds up!
You get to write off lots of kinds of business expenses without being incorporated. But incorporation may reduce the amount of tax you pay on your profits. As you make more money, a corporation can help you reduce the amount of personal taxes that you owe, also called your tax liability.
A general note that I’m not a lawyer. I’m giving generic answers to generic questions to educate the users of this site. The information in this post is not a substitute for personal legal advice for your specific situation.
LLC: The right choice for the vast majority of small business entrepreneurs is the LLC. Your personal liability is limited (the LL in LLC) in case of business losses or a lawsuit. It’s inexpensive to set up and has the flexibility to be taxed as a sole proprietorship, partnership, S-corp, or C-corp as your business evolves.
S-corp: If you are a freelancer, service provider, or solo consultant operating a highly profitable business, establishing an S-corp may make more sense. You pay yourself a reasonable salary as an employee and can also give yourself dividends, which aren’t subject to payroll taxes.
An LLC and an S-corp both give you the flexibility to benefit from the profits of your company today.
C-corp: In a C-corp, you’re keeping the value and growth inside the company in the form of equity. You can receive a salary as an employee if you have an operating role in the company. Dividends are typically not granted until the company is very established and highly profitable. Many public companies don’t pay dividends.
If you plan to take investment from a venture capital fund or offer stock options as compensation, you’ll need a C-corp. Investors generally want to have preferred and common stock classes (not possible in an S-corp) and a reasonably standardized set of management roles and business operating structures (not required in an LLC). Venture funds don’t qualify as “natural persons,” so they can’t invest in S-corps.
There are always exceptions. Certain classes of investors may want the more immediate tax benefits of getting a K-1 to participate in operating losses. Individual investors or qualified angels may not care how you’re structured if it’s just you or a few owners. VCs sometimes invest their personal money, which isn’t tied to a fund.
But if you know you want to pursue full-fledged venture capital firms like Forerunner Ventures, Cowboy Ventures, and Female Founders Fund for investments, form as a Delaware C-corp from the beginning.
2018 tax calculator – If you are a California operating company, check out this handy estimator for your total tax burden (including California Franchise Tax) as an LLC, S-corp, or C-corp.
BizFilings Incorporation Wizard – if you are still unsure about whether you need a C-corp, S-corp, LLC, limited partnership (LP) or limited liability partnership (LLP), try this simple wizard. You don’t have to provide any personal information or be contacted by the company. BizFilings also has a comparison chart for the three most likely options.
Stripe Atlas – a turnkey resource for Delaware LLCs and C-corps for global internet companies. Online payment processor Stripe has partnered with global law firm Orrick to package a Delaware C-corp or LLC, bank account, and global payment processing account for you. They include all of your C-corp documentation and issue stock to your shareholders. They also have a conversion package if you’re ready to move your LLC to a C-corp.
Converting from an LLC to a Delaware C-corp – Nolo has gathered all the steps and information you need to convert from an LLC or corporation in any state to a Delaware C-corp. Delaware has simplified the steps and forms, but you still will want a pro to help you with the paperwork, required agreements, and filings. Taking a round of funding costs $30,000 – $60,000. Don’t cheap out on getting your paperwork right.