One of the questions I get the most often from new business owners: how should I incorporate? At the very beginning, my general answer 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.
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. Think of moving your personal stuff into one bubble and your business stuff into another. If risk to your personal assets like your house and retirement savings keeps you up at night, this is a good reason to invest in an incorporated structure.
Taxes: Businesses and people are taxed at different rates by the IRS. At the federal level, businesses are taxed on their profits. Deductible expenses like 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 regardless of your incorporation status. 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.
Please note, I am not an attorney and this post is not legal advice. I’m providing general business information for educational purposes only. Please consult with your account or attorney for advice specific to your personal needs.
So what are the different ways you can form a business?
Sole proprietorship or partnership: These business types are you doing business as you, the human. You can have a “doing business as” (dba) name and EIN, but legally, you’re functioning as a natural person. If you start selling products or services, you’ve formed either a sole proprietorship or a partnership. (A partnership has more than one owner.) This structure does not separate your personal stuff from your legal stuff. If you’re testing out a new idea and you don’t have much personal risk, you may choose to operate as a sole proprietorship to start. In this structure, you will pay 15.3% federal payroll taxes for social security and Medicare on any owners draws you take for your compensation.
LLC: The right choice for the vast majority of small business entrepreneurs is a limited liability company or LLC. The limit is that, if you respect the rules of the structure, your personal assets are separated from your business assets. Your personal liability is limited (the LL in LLC) in case of business losses or a lawsuit. LLCs are usually inexpensive to set up, let you define the terms of the operating agreement, and have the flexibility to be taxed as a sole proprietorship, partnership, S-corp, or C-corp. In this structure, you will also pay 15.3% federal payroll taxes for social security and Medicare on your owner’s draws.
S-corp: If you are operating a highly profitable business, establishing an S-corp (or choosing to have your LLC taxed this way) may reduce your tax bill. You’ll need to hire yourself as a W-2 employee and pay yourself a reasonable salary. You can also give yourself distributions of profit, which aren’t subject to payroll taxes. S-corps have lots of limitations, including only one class of stock, 100 or fewer shareholders, and only US citizens or permanent residents as shareholders. You’ll also need to file a separate tax return for the business. But if you’re highly profitable, the administrative effort may be worth it to make your salary a business expense and take distributions free from 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, your investors are likely to ask you to convert to a C-corp. Investors generally want to have preferred and common stock classes (not possible in an S-corp) and a 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 venture capital for investments, form a Delaware LLC or C-corp from the beginning.
Resources:
Comparison of types – Our partners at CorpNet have summarized the seven most common types of business formations.
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.
Wolters Klewer 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.
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.
