Why Startups Should Always Incorporate
There are many business structures available to startups and ecommerce sellers including LLCs and corporations. The best business structure for any business owner hoping to grow their company, raise venture capital funding, and protect their personal assets from liabilities incurred by their business is a corporation.
In this article, we'll help you weigh the benefits of incorporation. We’ll explore the similarities and differences between LLC and corporation structures and including their unique tax and management structures, distinct maintenance requirements, and how each structure can impact your funding viability.
What is a corporation?
A corporation is a business structure that is a separate legal entity from its owners. It is created by filing articles of incorporation with the Secretary of State in a chosen location, and is a highly regulated type of business structure.
The Internal Revenue Service (IRS) imposes regulations on corporations that create predictable legal criteria under which the company must operate. These regulations make corporations more attractive to investors, who are often attracted to their predictable nature.
While the investors who choose to fund startups are often comfortable with a certain degree of risk, the more factors that contribute to predictability the better. Predictability increases the likelihood of an investor receiving a return on investment.
Plus, in some cases, investors are legally only able to invest in corporations. Any founder looking to get funded by venture capital firms should incorporate for this reason alone.
Below, we’ll define the characteristic ownership, management, and tax filing requirements of corporations to give you the full context of their benefits.
- Ownership: C- and S-corporations are owned by shareholders. Shareholders do not have to be owners to the business or involved in the business’ general operations. Shareholders generally participate in annual shareholder meetings and vote on major decisions such as changing the company’s constitution, declaring dividends, or liquidating the company.
- Management: Corporations have strict management and maintenance structures. First, there must be a board of directors that aims to increase company profits. Next, there must be separate officers to manage daily operations, such as a CEO, CTO, or COO. Founders must also write and abide by the bylaws of the corporation, maintain comprehensive documentation, hold annual shareholder and board meetings, and file annual reports to the Secretary of State.
- Taxation: A corporation is taxed as a distinct entity from its owners, who pay taxes on their personal filings. Corporations are taxed on business income and any dividends paid are also taxed (this is known as double taxation). S-corporations can opt to file as a pass-through entity but the default is to file as a distinct entity.
What is an LLC?
Limited liability companies (LLCs) are a sort of hybrid between corporations and sole proprietorships, born out of a gap in the business formation environment.
Corporations are highly regulated distinct entities; sole proprietorships are notably flexible. Corporations are considered independent entities and provide business owners with protection over their personal assets if their business is faced with a liability; sole proprietorships are not independent of their owners, and business owners are responsible for all liabilities.
LLCs draw features from each of those business structures to offer a middle-of-the-road structure with the operational flexibility and legal entity distinction of a sole proprietorship and the limited liability protection of a C- or S-corporation.
For LLCs, the limits of this liability extend to the amount that members invest in the company. If your company owes on a lawsuit which it can’t afford to pay, your personal funds will only be drawn up to your investment amount, if at all.
- Ownership: LLCs are owned by members of the LLC with equity. “Member” in this business structure means owner. Each member’s percentage of ownership is determined by LLC members.
- Management: LLCs have great flexibility when it comes to management. They can be either member-managed or manager-managed. Member management means that one of the members is running the operations and maintaining the business’ legal requirements, whereas manager-managed means that a non-owner is hired to handle these responsibilities. LLCs can be run by an individual or group, as determined by the members. Together, members also form an operation agreement against which to uphold operational standards.
- Taxation: By default, LLCs are taxed as a pass-through entity. A pass-through entity is taxed on the LLC members’ income rather than the company’s income. The IRS considers LLCs (and sole proprietorships) to be disregarded entities, which means that they are taxationally indistinct from their business owner(s). As a result, the income of the business is passed through to the business owner(s), who then pay tax on behalf of the company.
LLCs can elect to be taxed as S-corporations if the members prefer not to use the standard pass-through structure.
How does limited liability work?
A defining characteristic of both LLCs and corporations is the provision of limited liability, which is a part of the corporate veil. This is one of the most important characteristics that LLCs share with corporations. This veil creates a distinction between your personal liability and the company’s liability, which helps protect your personal assets from being impacted by any business charges or debts. In other words, you shouldn’t have to pay out-of-pocket for your company’s costs. Both business types need to maintain their limited liability by adhering to legal documentation and filings for their business.
For LLCs, the limits of this liability extend to the monetary amount that members have invested into the company. Let’s say a member invested $10,000 in their LLC and the LLC owes $150,000 on a lawsuit. If the business is not able to cover the cost, then the member will only be potentially liable for $10,000 on that suit due to the protection of the liability limit.
Corporations have the same protection. This means that the corporation’s employees’ and officers’ personal assets, including homes, boats, bank accounts, or cars, will not be seized in order to pay off liabilities that the business incurs.
This corporate veil can be pierced, which opens owners up to personal liability. It’s of personal and professional interest to fortify your company’s corporate veil as much as possible. You can do so by remaining compliant, keeping documents accurate and up-to-date, and maintaining segregation of your personal and business finances.
LLCs versus corporations: Key differences
Here’s a table of key differences between LLCs and corporations that you can use as you decide your business structure.
Which business structure is right for me?
An LLC might be a good choice if you need operational flexbility and want to avoid double taxation. A corporation might be a good choice if you want easier access to investors and a global market.
If you’re a startup, we’d recommend incorporating.
Corporations have many regulatory requirements. These strict must-haves can seem limiting, but they also offer a concrete element of predictability for potential investors and shareholders.
Since LLCs are member-owned, the business entity is vulnerable if the founders leave the business. Unless it has been legally established that the baton will be passed to another member, the company could be dissolved. On the other hand, if a founder leaves her corporation, it will continue to exist as an independent legal entity. If you choose to structure your business as an LLC, ensure that your startup is set up to last by preparing for this possibility before it arises.
Some businesses choose between corporations or LLCs based on the nature of their industries. For example, an insurance brokerage would likely be more successful as a corporation because of the many regulations that the insurance industry has for businesses. An LLC doesn't necessarily need to comply to these regulations. An entity that holds appreciating assets such as a real estate holding company might prefer an LLC, since it still offers protection for assets but is taxed more flexibly on personal income.
Ultimately, the best decision for your business is an educated one. Be sure to set up meetings with law and tax professionals who have proven experience with these business structures to advise you. They will be able to provide insights that could make this decision easier and wiser.