This is Part I of KJK’s “Startups 101” series.
One of the earliest legal decisions a founder makes is what kind of entity to form and in which state to form it. That choice affects taxation, governance and future investment.
Entity Types
For most startups, the practical choice comes down to two legal forms: a limited liability company (LLC) or a corporation. How the entity is taxed is a separate question layered on top. Either form can be taxed as a C corporation or, if it qualifies, as an S corporation under the Internal Revenue Code. Put simply, “C” and “S” describe how an entity is taxed, not what kind of entity it is.
An LLC is often a strong fit for closely held businesses, family-owned ventures, and professional service firms. LLCs generally offer liability protection, pass-through tax treatment by default, and substantial flexibility in governance through an operating agreement, often with fewer formalities than a corporation. That combination, simplified governance, default flow-through taxation, and fewer formalities, makes the LLC a sensible choice for many early-stage ventures. And in most states, converting an LLC to a corporation later, when investors expect it, is relatively straightforward.
An LLC’s governance lives in its operating agreement, which is essentially a private contract among the members. The statute imposes only minimal requirements, and that is the appeal: the members can largely write their own rules. It is also the risk. Because no state official ever reviews the document, an operating agreement can be improvised or left incomplete, leaving important questions unanswered, such as how decisions get made, how disputes are resolved, how a member can exit, and what happens if a member dies or becomes incapacitated.
Some of this becomes moot once outside money arrives. Institutional and venture investors typically impose their own governance and equity structure as a condition of funding, and they usually expect a corporation, so the founders’ early design gives way to the investors’ template in any event.
A corporation is often the better fit for startups that expect to raise outside equity capital. Investors frequently prefer the corporate form because it supports multiple classes of stock, conventional equity incentive arrangements, and a more familiar path for venture financing and exit transactions. The trade-off is the inverse of the LLC’s flexibility. A corporation’s governance is set largely by statute, with requirements around meetings, notice, and the rights of equity holders defined far more rigidly than the comparatively light requirements of the LLC statute. For a company headed toward institutional financing, that rigidity is a feature rather than a burden, because it is the structure investors already expect.
Taxation: C or S
Whatever its legal form, the entity has to be taxed somehow, and the basic difference between the two classifications is straightforward. C status means taxation at the entity level: the company pays tax on its profits, and the shareholders pay again when those profits are distributed as dividends. S status is a federal tax election, not a separate kind of entity, that allows flow-through taxation instead. The entity itself pays no federal income tax, and profits and losses flow through to the equity holders’ personal returns. Timing matters here. A corporation needs no filing to be taxed as a C corporation, since that is the default; the S election is the affirmative step, made on IRS Form 2553 and due no later than two months and 15 days after the start of the tax year it is to take effect (measured from formation for a new entity), which for a calendar-year company usually means by March 15. Miss that window and S treatment ordinarily waits until the following year, absent late-election relief.
The catch is eligibility. S status is available only to entities that meet restrictive federal rules, including a single class of stock, no more than 100 shareholders, and limits on who may hold equity. Those constraints are usually incompatible with venture financing, which depends on preferred stock and institutional investors, so growth companies expecting to raise outside capital generally remain C corporations.
State of Formation
The choice of formation state is separate from where the company will actually operate. Although founders often default to their home state for the state of formation, the right answer depends on the company’s growth plans and investor expectations. Every state writes its own statutes and develops its own body of case law interpreting them, and the differences can be material. A review of the relevant local-law fundamentals belongs in any final decision.
Delaware remains the leading choice for many venture-backed and high-growth companies because of its well-developed corporate law, Court of Chancery, and the market familiarity that investors and counsel often value. Decades of investor-led companies have produced a statutory framework, and a specialized business court to interpret it, that professional investors and their counsel know well and rely on. The flip side is that those same investors would rather not learn the quirks of another state’s law, so a Delaware entity simply removes a point of friction from a financing. Still, Delaware is not automatically the best option for every business.
Delaware’s advantages can also come with possible drawbacks. Delaware imposes an annual franchise tax on corporations, though the burden is often overstated. The tax can be figured two ways. The default method shown on the state’s bill is based on the number of authorized shares and can produce an alarming number for a startup that has authorized millions of shares. The second method, based on the company’s assumed par value capital (a function of its issued shares and gross assets), almost always yields far less, frequently at or near the minimum, so a company that simply pays the default figure can overpay badly.
A company formed in Delaware but operating elsewhere must also qualify to do business as a foreign entity in its home state, which generally means two sets of filing fees, a registered agent in each state, and possibly duplicative annual compliance obligations.
And Delaware’s courts are an expense of their own: the Court of Chancery is sophisticated, but litigating there is costly, and a founder who has agreed to a Delaware forum can be surprised to find an early dispute unfolding in another state’s courts under another state’s rules.
For an early-stage company conserving cash and with no near-term financing plans, that added expense and administrative burden may outweigh the benefits of Delaware law.
For a founder-owned company with no near-term plan to raise institutional capital, forming in the business’s home state may be more practical and cost-effective. For example, if the company will operate only in Ohio, organizing in Ohio may help avoid the added cost and administrative burden that can come with forming in one state and qualifying to do business in another. Ohio is also relatively business-friendly from a maintenance perspective, because Ohio corporations and LLCs do not need to file annual reports with the Secretary of State.
The Bottom Line
There is no one-size-fits-all answer. The right entity and formation state depend on the company’s ownership structure, tax goals, financing strategy, and long-term plans, so founders should evaluate those issues with legal and tax advisors before filing organizational documents.
Just as important, none of it is permanent. An entity can convert, a tax election can be made or revoked, and a company can reincorporate in another state when the time is right, usually as part of a financing. The early decision does not have to anticipate every future contingency.
If you are launching a new venture and want to structure it thoughtfully from the outset, please contact attorneys Andrew Wilber (AJW@kjk.com), Emily Korthaus (ELS@kjk.com) or Ted Theofrastous (TCT@kjk.com).