There are 5 main types of organizations that are founded. Each comes with positives and negatives and there’s really no perfect formula when we’re first starting out, but there are some triggers that force us to switch to various types of businesses. The ones we’ll cover in this article include the following:
The Sole Proprietorship
A Sole Proprietorship is an organization that is, well, a person. This is a company who is doing business as (thus a DBA) the name of an organization. A DBA is fairly simple to create and the owner doesn’t have to file a tax return on behalf of the company being created. But, there can only be one owner and one investor in the organization and there’s no liability protection. That means that the personal assets of the owner of the business can be pursued if the business goes into debt for more than the assets of the business can cover.
That liability protection is key and so in case we’re concerned about legal issues (most people should be), it’s usually best to just start as an LLC.
The next stage we normally see when talking to newer startups is an LLC, or Limited Liability Corporation. Here, we’re increasing the administrative upkeep and accounting burden of the business. This means we have to file a separate tax return for the LLC and keep a separate ledger in support of that. But, the business is no longer just us doing business as the owner and we get liability protection and we have more options for how to file those taxes at the end of the year.
S Corp is often selected for smaller corporations. The benefit of an S Corp is that tax is only taken out on shareholders. There can be up to 100 shareholders, but only one class of stock and those shareholders have to be US citizens and not foreign or institutional investors (which means a venture capital firm can’t invest but individuals in the US can). There’s a bit of extra documentation required for annual filings, but the S Corp is common for organizations that don’t foresee hyper growth.
Most of us will end up with C Corporations eventually, if all goes well. The C Corp will be necessary for international expansion or for organizations that plan to go public as there’s an unrestricted number of shareholders in a C Corp and they can be located in foreign countries. There’s a lot of liability protection, but the legal entity must be separate from the individual and so there’s a lot of extra paperwork, which comes with cost to process and file. That extra paperwork is also necessary because C Corps are subject to double taxation, which is to say they are taxed at the corporate level and shareholders are taxed. But, it’s part of the cost of doing business when going international, going public, or bringing in institutional investors like funds. And, C Corporation profits are taxed at lower rates, to help soften the blow.
Some organizations aren’t meant to make money, but instead meant to raise money for a given cause. This might be in support of a movement, to build awareness, to establish a means for charitable giving, or create a museum. The organization isn’t required to pay income tax from the contributions and in fact makes those contributions tax deductible for the people donating. There are a number of requirements, like filing paperwork for a separate legal entity both federally (e.g. a 501(c)3 and rather than have an owner they have a board of directors. Additionally, most will require operate taxes be filed annually and paying fees to state and federal entities.
Overall, most startup organizations that seek investment are going to be an S Corp or a C Corp. This provides a structure where shares can be allocated to the investor. An organization can revoke an S election at any point and issue C corporation shares. While this change can happen at any point, it must happen by the 15th day of the 3rd month of the tax year in order to classify as a C Corp on corporate taxes.
The IRS will automatically require moving to a C Corp when earnings, profits, and income exceed 25% of gross income for three years in a row. But by then any organization will likely have a business where the tax liabilities would have caused us to do that anyways. Additionally, once the election of an S is revoked we likely can’t move back to that type of corporation for 5 years.
These are things that we should bring in business advisors and tax specialists to deal with. This article isn’t meant to be tax advice but more just a broad overview of the types of companies startups often form. The advisor can also expand on where the corporation is formed (e.g. many SaaS startups form in Delaware for a variety of reasons). But a savvy lawyer and business advisor will help navigate all those waters and more so we should never jump into this stuff without a little help from them!