The US is the leading country in terms of the number of startups (71,153), with India coming in second with a little over 13,000 startups and the UK coming in third with over 6,000. Some of the most profitable startups in the world deal in industries such as e-commerce, Chrome extensions, mobile apps, Enterprise SaaS and similar. A select few (think TikTok) have reached unicorn status (received a valuation of $1 billion without being listed on the stock market), which is the ultimate aim of any startup founder. If you have a great idea, and you have attracted sufficient investment to put your business plan into practice, make sure you have laid the foundations for success by following a few key strategies.
Choosing the Right Legal Entity for Your Startup
There are various options when it comes to setting up your startup legally. One common structure is a sole proprietorship, which does not require a registration process. This structure is fine if you work alone but if another person comes along, legal doubts can arise with respect to factors like who owns the intellectual property of a specific technology. LLCs are also popular because they free founders from being personally liable for their company’s debts. The cost of starting an LLC is low and you can simply include the entity’s financial result when you file your personal taxes. If you are interested in the idea of an LLC, forming your company in your home state is advantageous because most of your business may come from local clients. However, you should also consider the potential tax advantages of filing in another state.
What States are Most Advantageous for Filing an LLC or Corporation?
Some states offer company founders more advantages than others. For instance, if you are founding an LLC in Texas, you can benefit from this state’s solid business environment, asset protection for LLC owners, tax benefits, and a good degree of flexibility. States that have a particularly good reputation for offering advantages, meanwhile, are Delaware, Nevada, and Wyoming. For instance, LLC founders in Wyoming don’t have to pay any business tax or franchise tax at all. This state also allows owners to appoint a third party to represent their stock or shares and vote on their behalf. This affords them complete anonymity. Nevada, meanwhile, is all about simplicity; owners don’t have to create an operating agreement or hold annual meetings. Delaware is also of interest because it does not tax out-of-state income. Even if the majority of your dealings take place in other states, you will not be taxed by the state if your LLC was founded there. These same states also offer significant advantages to corporations. For instance, Nevada has a wide range of freedoms from state taxes, and it offers enhanced privacy to directors, investors, and other parties wishing to remain anonymous.
LLCs and Corporations: Similarities and Differences
If you are seeking to attract big investors—the kind that can take you to unicorn status—then an LLC may not be the ideal structure. Rather, a corporation is of greater interest. There is a significant overlap between LLCs and corporations. For instance, both offer their owners limited liability, though LLCs are taxed like partnerships or sole proprietors and owners are considered to be self-employed, Corporations, meanwhile, treat corporate shareholders like employees. If you choose to incorporate, you will have to choose between a C and an S corporation. The former is a separate entity with respect to taxes and has a low 21% tax rate. In the case of S corporations, profits are taxed at the shareholders’ respective rates.
Why Investors Prefer Corporations
Investors (particularly venture capitalists) may lose interest quickly in your idea if they discover your company is an LLC. They prefer to deal with corporations for many reasons. First of all, while transferring or selling membership or ownership in an LLC is difficult, trading shares in a corporation is easy. Moreover, most venture capitalists will insist on investing in C corporations because, unlike LLC members, C corp shareholders only pay taxes on profits if they received a dividend. In essence, C corps undergo a process of double taxation. First, the company pays taxes on its revenue as a business. Later, the individual shareholders pay taxes on the amounts they receive. With an S corporation, meanwhile, the investor or venture capitalist would be required to pay taxes on profit even if they were not paid a distribution. This is also true of an LLC, which requires all owners to pay tax on the business’s annual earnings, regardless of the existence or not of dividends.
C Corps Have a Streamlined Tax Paying System
C corps also make it easier on investors at the tax-paying stage. When investors have partial ownership of an LLC, they have to receive a K-from from the LLC prior to filing their personal taxes. The taxation process for C corps, on the other hand, is significantly less laborious.
Selling One’s Interest in a Business
Investors prefer to be involved in a C corp because they can easily exit the business if they prefer to invest their money elsewhere. This can be achieved by selling their shares in the company. When one sells partial ownership in an LLC, they have to find a buyer who is interested or sell to current owners for a specific amount of money. The latter is then subject to significant taxes from the government. Ridding oneself of one’s interest in a C-corp, on the other hand, is tax-free. One exemption commonly relied on is the Small Business Stock exemption in Section 1202 which states: “In the case of a taxpayer other than a corporation, gross income shall not include 50% of any gain from the sale or exchange of qualified small business stock held for more than five years.” In other words, investors who have held an investment in preferred or common stock for this period of time may be able to leave the company without paying taxes on earnings up to a maximum of $10M.
Founding a unicorn startup is a challenging feat, and it helps to have a sound legal strategy on your side. If you wish to reach unicorn status, you should do your best to attract investors. This goal can be achieved by selecting the right legal structure for your company and by choosing to fund your LLC or corporation in the most advantageous state.
