On LLCs & corporations

Every so often I re-figure out what the deal with various US incorporation structures is and then forget it all over again. No more!
Here are my notes on what the distinctions are between various ways to incorporate, tax implications, and when you should consider them. Reader beware: these are personal notes formed from cursory research, and not tax advice.

Incorporation vs tax treatment

There are two separate axes at play here, and understanding them as separate helps
notion image

Incorporation

You incorporate with a given state, ie: register as a business entity, and agree to be judged by their courts and laws.
You can do business as an unincorporated entity, where you don’t file any paperwork, and just get started! You open bank accounts in your name, and do the same for loans, leases and such. You may call this a sole proprietership if you’re one person, or a partnership if you’re doing this with others.
Otherwise, you might register as an LLC (Limited Liability Company). Why would you register as an LLC? Well, as the name suggests you limit liability. If you get sued or your business has outstanding debts that it can no longer afford, the debtors cannot come after your personal assets.
One other benefit is that it might just help you keep books separate: it gives you a separate entity and helps you avoid comingling funds. Finally, as we’ll see later: an LLC has a lot of flexibility in how it gets taxed, that a sole proprietorship does not.
Lastly, you can register as a corporation. Corporations are generally just more rigid than LLCs, and provide well known structures. There are very few things you can do with a corporation that you can’t with an LLC.
But - this rigidity is beneficial. Corporations usually insist on a certain governance structure (ie: having a board with officers), and are hence are more predictable to investors. If you’re raising outside investment, it’s pretty common to need to be a corporation.

Tax treatment

While incorporation is a matter between you and a state, tax treatment is mostly a matter between you and the IRS. There are two major forms of tax treatment.
First, there’s the passthrough tax treatment. Everything is pretty much treated as ordinary income that goes on the members’ tax returns. The business entity itself isn’t taxed, and doesn’t hold money from year to year.
This is the simplest form - and often means you can avoid paying a tax-preparer early on. You just file a schedule C with your individual tax return.
The other tax treatment is the corporate tax treatment. Here: the corporation by default holds onto money from year to year, and is taxed on its profits annually. If the corporation decides to distribute money to shareholders, it may, and this is usually taxed as a qualified dividend (at a lower tax rate than ordinary income).
One issue here is the so-called “double taxation”: where you’re taxed once at corporate tax rates, and once again on your dividend. But this is less of an issue since the 2017 corporate tax cuts.

Choose your own tax treatment

Which tax treatment applies to your entity?
If you’re not registered at all, it’s always pass-through.
If you’re an LLC: you can choose either!
If you’re a corporation: you can always choose to be treated as a corporation, but in certain circumstances, you can choose to be treated kinda like a passthrough entity.

S-Corps

An S-Corp (ie: a corporation that elects to be treated under Chapter 1 Subsection S of the IRS code) is the aforementioned way to be treated kinda like a passthrough entity.
In particular, an S-Corp is limited to: a) having at most 100 investors, b) being owned by only US residents, c) having only one class of stock.
The reason I say an S-corp acts kinda like a passthrough entity is because it has subtly different treatment of payroll taxes, that can be beneficial. But, like a passthrough entity, it doesn’t store any profits from year to year, rather distributing them every year.
Anyways, here’s the updated diagram from earlier to account for S-Corps:
notion image
The options are:
  • If you’re unregistered, you can only use pass-through taxation
  • If you’re an LLC, you can use any of the three options.
    • (You need to have <100 members who are all US-residents to do the S-Corp path)
  • If you’re a corporation, you can be treated as a S-Corp or a C-Corp
    • (You need to have <100 members who are all US-residents to do the S-Corp path)
One note is: you don’t get to pick this at tax-time, rather you generally need to pick this towards the start of the tax year + file an election.
By default, LLCs get pass-through taxation, and corporations get corporate taxation.

Tax flows

Okay, now that we’ve gone through how to access various tax treatments, and what they are, here are the overall tax flows.
notion image
notion image
notion image

Analysis

Passthrough+ (ie: S-Corps) can be seen as a slight optimization on regular passthrough. That is, the mandatory distribution is split into a “reasonable salary”, vs a distribution.
You get to pick the reasonable salary, and if the IRS disagrees they’re able to make you pay self-employment tax on your whole distribution.
Notably: this makes a big difference only if you’re able to pay yourself a reasonable salary of under $168k. There are companies whose whole deal is helping LLCs figure this out and saving upto ~$10k per year, see, Lettuce for example.
Corporate is very different - and is mostly useful if you’re hoping to do a lot of reinvesting. Notably: other formats mean you’re billed upto ~60% on new profits you carry from year-to-year, but corporate tax handling means you’re billed only ~20%. Additionally, C-Corps used to be more expensive in the past (before 2017) due to a maximum tax rate of about 35%.
At current tax rates, it can actually be kinda fine to have an LLC acting as a C-Corp that performs a lot of distributions.

Practical notes

Q: I’m not sure what kind of company I want to build, but maybe it would be a VC-backed company, but what entity do I use in the meantime?
Probably go with an unregistered entity for now. The main benefit of registering for now would be liability protection, and it’s likely fine to go without that in the short run, unless you think you’re super likely to be sued.
It probably makes sense to pick when you get closer. If you do anticipate liability, you could start with an LLC and convert later on.
Q: I’m definitely going to do a VC-backed company, what do I do?
Make a Delaware-registered C-Corp. It’s pretty much the only option.
You can start with an LLC and then convert to a C-Corp, but it’s kinda unclear why you’d do this if you’re already reasonably certain.
I’d consider Stripe Atlas for a simple one-off service, or Doola for some more complex help. There’s others like Doola around too.
Q: I’m planning to run a consulting business or other one-man shop, what do I do?
Make a LLC registered in your state of residence. Likely use passthrough taxation to start (or maybe S-Corp taxation).
Ask a CPA or tax lawyer or so for help after year one.

Appendix: On costs

How much does it cost for various administrivia?
Incorporation:
  • Stripe Atlas: $500
Annual registered agent:
  • (Mandatory if your business agent is out-of-state)
  • Stripe Atlas: $100
Annual federal tax filing for a C-corp:
  • OpticTax (Formerly CleerTax): $300+
Annual minimum state tax bills:
  • Delaware: $450 (C-corp), $300 (LLC)
  • California: $800 (waived for first year)
    • Required to pay for Delaware registered entities if you have employees/sales/business address in CA
Shutdown:
  • Stripe Atlas via LegalInc: $619 (LLC)
Additionally, you may want book-keeping, usually offered at ~$100-300/mo at low-touch book-keeping providers.
Overall, you’d see yourself paying about $1k/y, an additional fee for book-keeping if you decide on using it, and an additional ~$500 at incorporation and shutdown.

Appendix: QSBS & 83b

QSBS and 83b are two other terms you might hear about when setting up a C Corp. Both of these don’t apply to the main flows I’ve investigated above, ie: the above flows only look at distributions. Instead, these deal with stock sale: how much are you taxed at stock sale time?
This is actually the right way to think about it if you’re starting a company with the goal of it being a high-growth startup: you’re going to make any money not from distributions but from stock sales.
An 83b election applies to the fact that usually, you have stock vesting over a period of years, and you can instead elect to pay taxes on it all upfront. This is great for founders - since your initial tax value is ~nil, whereas after the 4-5 years of vesting, it could potentially be quite substantial. This also starts the timers on long term capital gains & QSBS earlier!
Once you own stock, if you sell it after >1y after you acquired it, you’re billed at long-term capital gains instead of ordinary income.
QSBS is an additional benefit: if you acquire stock when the company has less than $50m in assets, and then you sell it >5y after you acquired it, you can exempt upto $10m of gains from taxes. That’s quite significant.
Neither of these apply to contexts where you don’t sell stock though: so as a passthrough entity, they aren’t really relevant. Additionally, even though LLCs can be treated as C-Corps in some contexts, it seems messy/unclear/unusual to be able to get QSBS benefits for an LLC. It might be possible - but the advice online seems to be split, so contact an accountant.

On LLCs & corporations

Every so often I re-figure out what the deal with various US incorporation structures is and then forget it all over again. No more!
Here are my notes on what the distinctions are between various ways to incorporate, tax implications, and when you should consider them. Reader beware: these are personal notes formed from cursory research, and not tax advice.

Incorporation vs tax treatment

There are two separate axes at play here, and understanding them as separate helps
notion image

Incorporation

You incorporate with a given state, ie: register as a business entity, and agree to be judged by their courts and laws.
You can do business as an unincorporated entity, where you don’t file any paperwork, and just get started! You open bank accounts in your name, and do the same for loans, leases and such. You may call this a sole proprietership if you’re one person, or a partnership if you’re doing this with others.
Otherwise, you might register as an LLC (Limited Liability Company). Why would you register as an LLC? Well, as the name suggests you limit liability. If you get sued or your business has outstanding debts that it can no longer afford, the debtors cannot come after your personal assets.
One other benefit is that it might just help you keep books separate: it gives you a separate entity and helps you avoid comingling funds. Finally, as we’ll see later: an LLC has a lot of flexibility in how it gets taxed, that a sole proprietorship does not.
Lastly, you can register as a corporation. Corporations are generally just more rigid than LLCs, and provide well known structures. There are very few things you can do with a corporation that you can’t with an LLC.
But - this rigidity is beneficial. Corporations usually insist on a certain governance structure (ie: having a board with officers), and are hence are more predictable to investors. If you’re raising outside investment, it’s pretty common to need to be a corporation.

Tax treatment

While incorporation is a matter between you and a state, tax treatment is mostly a matter between you and the IRS. There are two major forms of tax treatment.
First, there’s the passthrough tax treatment. Everything is pretty much treated as ordinary income that goes on the members’ tax returns. The business entity itself isn’t taxed, and doesn’t hold money from year to year.
This is the simplest form - and often means you can avoid paying a tax-preparer early on. You just file a schedule C with your individual tax return.
The other tax treatment is the corporate tax treatment. Here: the corporation by default holds onto money from year to year, and is taxed on its profits annually. If the corporation decides to distribute money to shareholders, it may, and this is usually taxed as a qualified dividend (at a lower tax rate than ordinary income).
One issue here is the so-called “double taxation”: where you’re taxed once at corporate tax rates, and once again on your dividend. But this is less of an issue since the 2017 corporate tax cuts.

Choose your own tax treatment

Which tax treatment applies to your entity?
If you’re not registered at all, it’s always pass-through.
If you’re an LLC: you can choose either!
If you’re a corporation: you can always choose to be treated as a corporation, but in certain circumstances, you can choose to be treated kinda like a passthrough entity.

S-Corps

An S-Corp (ie: a corporation that elects to be treated under Chapter 1 Subsection S of the IRS code) is the aforementioned way to be treated kinda like a passthrough entity.
In particular, an S-Corp is limited to: a) having at most 100 investors, b) being owned by only US residents, c) having only one class of stock.
The reason I say an S-corp acts kinda like a passthrough entity is because it has subtly different treatment of payroll taxes, that can be beneficial. But, like a passthrough entity, it doesn’t store any profits from year to year, rather distributing them every year.
Anyways, here’s the updated diagram from earlier to account for S-Corps:
notion image
The options are:
  • If you’re unregistered, you can only use pass-through taxation
  • If you’re an LLC, you can use any of the three options.
    • (You need to have <100 members who are all US-residents to do the S-Corp path)
  • If you’re a corporation, you can be treated as a S-Corp or a C-Corp
    • (You need to have <100 members who are all US-residents to do the S-Corp path)
One note is: you don’t get to pick this at tax-time, rather you generally need to pick this towards the start of the tax year + file an election.
By default, LLCs get pass-through taxation, and corporations get corporate taxation.

Tax flows

Okay, now that we’ve gone through how to access various tax treatments, and what they are, here are the overall tax flows.
notion image
notion image
notion image

Analysis

Passthrough+ (ie: S-Corps) can be seen as a slight optimization on regular passthrough. That is, the mandatory distribution is split into a “reasonable salary”, vs a distribution.
You get to pick the reasonable salary, and if the IRS disagrees they’re able to make you pay self-employment tax on your whole distribution.
Notably: this makes a big difference only if you’re able to pay yourself a reasonable salary of under $168k. There are companies whose whole deal is helping LLCs figure this out and saving upto ~$10k per year, see, Lettuce for example.
Corporate is very different - and is mostly useful if you’re hoping to do a lot of reinvesting. Notably: other formats mean you’re billed upto ~60% on new profits you carry from year-to-year, but corporate tax handling means you’re billed only ~20%. Additionally, C-Corps used to be more expensive in the past (before 2017) due to a maximum tax rate of about 35%.
At current tax rates, it can actually be kinda fine to have an LLC acting as a C-Corp that performs a lot of distributions.

Practical notes

Q: I’m not sure what kind of company I want to build, but maybe it would be a VC-backed company, but what entity do I use in the meantime?
Probably go with an unregistered entity for now. The main benefit of registering for now would be liability protection, and it’s likely fine to go without that in the short run, unless you think you’re super likely to be sued.
It probably makes sense to pick when you get closer. If you do anticipate liability, you could start with an LLC and convert later on.
Q: I’m definitely going to do a VC-backed company, what do I do?
Make a Delaware-registered C-Corp. It’s pretty much the only option.
You can start with an LLC and then convert to a C-Corp, but it’s kinda unclear why you’d do this if you’re already reasonably certain.
I’d consider Stripe Atlas for a simple one-off service, or Doola for some more complex help. There’s others like Doola around too.
Q: I’m planning to run a consulting business or other one-man shop, what do I do?
Make a LLC registered in your state of residence. Likely use passthrough taxation to start (or maybe S-Corp taxation).
Ask a CPA or tax lawyer or so for help after year one.

Appendix: On costs

How much does it cost for various administrivia?
Incorporation:
  • Stripe Atlas: $500
Annual registered agent:
  • (Mandatory if your business agent is out-of-state)
  • Stripe Atlas: $100
Annual federal tax filing for a C-corp:
  • OpticTax (Formerly CleerTax): $300+
Annual minimum state tax bills:
  • Delaware: $450 (C-corp), $300 (LLC)
  • California: $800 (waived for first year)
    • Required to pay for Delaware registered entities if you have employees/sales/business address in CA
Shutdown:
  • Stripe Atlas via LegalInc: $619 (LLC)
Additionally, you may want book-keeping, usually offered at ~$100-300/mo at low-touch book-keeping providers.
Overall, you’d see yourself paying about $1k/y, an additional fee for book-keeping if you decide on using it, and an additional ~$500 at incorporation and shutdown.

Appendix: QSBS & 83b

QSBS and 83b are two other terms you might hear about when setting up a C Corp. Both of these don’t apply to the main flows I’ve investigated above, ie: the above flows only look at distributions. Instead, these deal with stock sale: how much are you taxed at stock sale time?
This is actually the right way to think about it if you’re starting a company with the goal of it being a high-growth startup: you’re going to make any money not from distributions but from stock sales.
An 83b election applies to the fact that usually, you have stock vesting over a period of years, and you can instead elect to pay taxes on it all upfront. This is great for founders - since your initial tax value is ~nil, whereas after the 4-5 years of vesting, it could potentially be quite substantial. This also starts the timers on long term capital gains & QSBS earlier!
Once you own stock, if you sell it after >1y after you acquired it, you’re billed at long-term capital gains instead of ordinary income.
QSBS is an additional benefit: if you acquire stock when the company has less than $50m in assets, and then you sell it >5y after you acquired it, you can exempt upto $10m of gains from taxes. That’s quite significant.
Neither of these apply to contexts where you don’t sell stock though: so as a passthrough entity, they aren’t really relevant. Additionally, even though LLCs can be treated as C-Corps in some contexts, it seems messy/unclear/unusual to be able to get QSBS benefits for an LLC. It might be possible - but the advice online seems to be split, so contact an accountant.