There are a number of legal alternatives when forming a new business: Limited Liability Corporation (LLC), S Corporation, C Corporation, Partnership, Limited Liability Partnership (LLP), and Professional Services Corporation (as well as others). The two most common forms for tech startups are LLC’s and C Corporations (or specifically, Delaware C Corps).
An LLC is owned by “members,” whose rights and obligations are governed by an Operating Agreement. LLC’s are very flexible, in that the Operating Agreement can allow the members to determine: how profits and losses are allocated; how the LLC shall be governed; and how membership units are transferred or sold to third parties. An LLC also avoids “double-taxation.” The LLC does not, itself, pay taxes. Rather, profits flow through directly to the members, and the individual members pay taxes on such profits.
By contrast, a C Corp pays taxes. Its shareholders are only taxed if the corporation pays a dividend, or the shareholder sells its stock for a gain. Therefore, if a C Corp makes a profit and pays taxes on it, and then the declares a dividend on which the shareholders pay a tax, there is a “double tax.” C Corporations also must abide by a number of formalities in their operation.
C Corporations have some advantages over LLC’s, especially if you plan to raise outside investment. Many investors (such as venture capital funds) do not want or cannot invest in LLC’s, due to the flow-through nature of the tax liability. In other words, they do not want to have their investments complicate their personal tax returns. If you are offering equity to employees, then it is easier to do so with C Corps than it is with an LLC.
Delaware is a popular option for incorporation, as the state has created laws and regulations that are advantageous to growth businesses. A business does not need a physical presence in Delaware to incorporate there.
Many professionals will advise that a C Corp is preferable if you plan to grow your business with outside investment. This opinion is not universal, however, and it is not always the best option.