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What Business Entity Is Best For A Startup

Written June 4, 2017

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We hate to give a lawyer answer, but . . . it depends. Are you selling cookies or software? Do you think you'll be seeking venture capital down the line? How many people are starting the business?

If you plan to seek VC funding, the answer is almost always a Delaware C-Corporation. The laws in Delaware are clear, which leads to less uncertainty. Transactional costs are lower and investments are safer. Some VC firms won't even entertain a pitch from a company that's not incorporated in Delaware.

But if you're not planning to raise capital, tax implications will likely guide your decision. C-Corps, S-Corps, and LLCs all limit personal liability. But only S-corps and LLCs offer pass-through taxation.

Pass-through taxation means that business income is not taxed at the corporate level. Rather, it "passes through" and the owner(s) includes the income on their personal tax return.

Pass-through taxation has three main benefits:

  • it's simple
  • there is no "double taxation" and
  • business owners may be able to take a net operating loss deduction on their personal income taxes

Simplicity There's no doubt that adding a Schedule C to your personal income tax return is easier than filing a separate corporate tax return. But corporate tax filings aren't as difficult as they used to be. There are many reputable services available online that have modernized the process. Check out Start.law, Xendoo and Taxfyle for some options.

Double Taxation "Double taxation" refers the same income being taxed twice. First, it's taxed as corporate income. Then it's taxed as personal income when it's issued to a shareholder in a dividend. But many startups don't issue dividends. (Amazon, Facebook, and Tesla to name a few). Instead, profits are re-invested in the company, which results in a higher share price. Founders gain wealth as the value of their shares increases. They can also take a salary, which is a business deduction for the company.

NOL Deduction The final benefit of pass-through taxation is the net operating loss deduction. The net operating loss (NOL) deduction is a big deal because it allows you to offset one year's losses against another year's income. It's called a carryover. For example,

Tax YearLoss/IncomeTax Owed Without NOL CarryoverTax Owed With NOL Carryover
2021- $50,000$0$0
2022+ $100,000$22,000$11,000

(This assumes a 22% tax rate)

This deduction can be very helpful for bootstrapping startups, but there are a host of things to consider.

  • NOL is calculated based upon the owner's entire taxable income. So if a founder is working a six-figure day job, this deduction may not be available.

  • S-corporations cannot take investments from business entities. If a startup takes funding from a VC group, the startup will automatically convert to a C-corporation. And not be able to revert back to an S-corporation for five years. So if you want to seek funding, but also take advantage of the NOL deduction, careful planning is necessary.

  • The NOL laws are in flux. It's a safe bet that you'll be able to carry a NOL forward, but the amount of income you can offset may change. For tax years 2021-2025, you are able to offset 80% of income.

The bottom line on entity choice? Seek professional advice so that your company structure supports your goals and limits your tax liability.

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