The C-corp, still the vanilla default
Why Y Combinator keeps pointing founders at a form whose headline tax rate is 35%
Contents 4 sections
Combinator hands every incoming batch a template that produces a Delaware C-corporation with 10 million authorized shares, and it does this on purpose. The form is older than the venture industry, the tax rate is higher than almost any alternative, and every sophisticated investor in the country expects to see it on the first page of the deck. That is the whole explanation.
The C-corp is the vanilla default for companies that intend to raise institutional money, issue stock options, and eventually sell. It is not a good default for most other businesses, and the gap between those two sentences is where founders get into trouble.
The case, briefly
A C-corp is a separate taxpayer. It files Form 1120, pays federal tax at 35%, pays state tax on top of that, and distributes whatever is left as dividends, which shareholders then pay tax on again. Everyone knows this, and venture-backed founders pick it anyway. Four reasons carry the weight.
First, preferred stock. A C-corp can issue multiple classes of stock with different rights — liquidation preference, anti-dilution, board seats, protective provisions. An LLC can be structured to do similar things through the operating agreement, but every fund's counsel has seen a thousand C-corp cap tables and roughly zero LLC cap tables they liked. Starting as a C-corp removes a conversion that costs real money and real time at a Series A.
Second, Section 1202. Stock issued by a qualifying C-corp and held for more than five years can, under current law, be excluded from federal tax on sale up to the greater of $10 million or 10x basis. The exclusion rate depends on when the stock was acquired: 50% for pre-February 2009 issuances, 75% through September 27, 2010, and 100% for stock issued after that date and held the full five years. The qualifying business asset and activity tests are strict — no more than $50 million in aggregate gross assets at issuance, active business requirement, certain industries excluded — but for a company that clears them, the 100% exclusion on a founder exit is the single largest tax preference in the code for private-company founders. It only runs through a C-corp.
Third, employee options. The §83 and §422 regime that governs incentive stock options and nonqualified options is built around corporate stock. Granting options out of an LLC is possible but uncomfortable: profits interests are the usual substitute, and they work, but they don't match what a senior hire expects to see when they ask about equity. If you plan to hire ten engineers and give each of them an offer letter with an option grant, a C-corp is the path of least resistance for both sides.
Fourth, the cap table itself. A share is a share. Anyone who has tried to explain an LLC membership-interest waterfall to a prospective investor understands why a single class of common stock, clean preferred on top, and an option pool underneath is worth its weight.
Formation mechanics
The standard incorporation is a Delaware C-corp. You file a Certificate of Incorporation with the Delaware Division of Corporations, pay the filing fee, appoint a registered agent in the state, adopt bylaws, elect a board, and issue founders' stock at par value. The paperwork is a Saturday afternoon if you know what you're doing and a week with a lawyer if you don't; most founders should pay the lawyer.
The authorized-shares trap is worth knowing before the February after your first year. Delaware's corporate franchise tax has two computation methods. The authorized-shares method, the default printed on the notice, scales with the number of shares the charter authorizes, regardless of how many are issued. A company with 10 million authorized shares and no meaningful assets receives a franchise-tax bill in the tens of thousands of dollars under that method. The assumed-par-value method, which almost every early-stage startup should use, scales with assets and issued shares and typically produces the $400 minimum. Delaware is not trying to collect the larger number from you; it is required by statute to print the larger number on the form. You elect the smaller method when you file. Founders discover this annually, in a panic, and it is the single most common source of "my startup owes $75,000" phone calls to startup lawyers in February.
Founders' stock is issued at formation for a nominal amount, usually tenths of a cent per share. The stock is typically subject to a four-year vesting schedule with a one-year cliff, enforced by a repurchase right that the company releases as time passes. Every founder receiving restricted stock should file a §83(b) election with the IRS within 30 days of the grant. The election lets the founder pay tax now, at a near-zero valuation, rather than as the shares vest against what will hopefully be a rising fair market value. Miss the 30-day window and there is no cure. It is the single most expensive administrative mistake a founder can make, and it is free to avoid.
The tax treatment, with the math
The federal corporate rate is 35%. State corporate tax varies — zero in a handful of states, high single digits in California and New York — and stacks on top. Assume a blended 40% combined rate for a coastal company as a working number.
A dollar of corporate income becomes 60 cents after corporate tax. Distribute that 60 cents as a qualified dividend and the shareholder pays 20% at the top federal bracket, plus the 3.8% net investment income tax where it applies, plus state tax on the dividend. The 60 cents becomes roughly 44 cents in the shareholder's pocket at the top bracket. The all-in rate on a dollar of corporate income distributed to a high-bracket owner is somewhere around 56%.
An S-corp or an LLC taxed as a partnership, by contrast, passes that dollar straight through to the owner, who pays ordinary-income rates — a top of 39.6% federal, plus state, plus self-employment tax where applicable, but only once. For a profitable operating business that wants to pull cash out annually, pass-through is cheaper, often by ten or more points on the dollar.
The C-corp math only works out if you are not distributing. Retained earnings grow inside the entity; the double tax is deferred until sale; and at sale, if §1202 applies, the exclusion can eliminate the second layer entirely for the first $10 million per founder. The structure rewards companies that reinvest, raise capital, and exit. It punishes companies that generate cash and pay it out.
Where this form doesn't hold up
Two kinds of businesses should not default to a C-corp in 2016.
The first is the profitable cash-flow business whose owners want the money. A consulting practice, an agency, a regional services company, a small software shop with no venture ambition — these businesses distribute most of what they earn. The double tax is not a theoretical concept; it is a real 10-to-15-point bite every year. An LLC or an S-corp serves them better.
The second is the small operator with no capital raise in view. A solo founder building a product business, a two-person studio, a side project that might someday be a company — these founders do not need preferred stock, do not need an option plan, and will not clear the §1202 asset tests in a way that matters. Forming a C-corp saddles them with separate returns, payroll formalities, and a franchise-tax calendar in exchange for benefits they will not use.
The pattern is simple enough. If the business plan includes the word "Series A," a Delaware C-corp is the right answer on day one. If it does not, the vanilla default is the wrong default, and the right form is whatever pass-through fits the jurisdiction and the owners.
The C-corp is the standard because the venture industry standardized on it, not because it is the cheapest or the simplest. It is, in 2016, a tax structure that optimizes for one outcome: a founder with basis near zero selling qualifying stock after five years. If that is the outcome you are building toward, the 35% rate and the double tax are rent you pay on a door that opens at exit. If it is not, the rent is simply rent.