# Why startups are Delaware C corporations

> Preferred stock, option plans, ISOs, QSBS and investors' own taxes all need a corporation; Delaware's statute and court are what the documents assume.

Source: https://lopifi.com/learn/why-startups-are-delaware-c-corps
Part of: Lopifi — US GAAP books on autopilot, checked by a CPA (https://lopifi.com)

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**Why do startups incorporate as Delaware C corporations?** Preferred stock, option plans, ISOs, QSBS and investors' own taxes all need a corporation; Delaware's statute and court are what the documents assume.

Venture-backed startups are overwhelmingly Delaware C corporations, and the reasons are specific. Each one below is a rule you can read.

## Preferred stock and option plans

A priced round sells **preferred stock**: a class with its own rights, a [liquidation preference](https://lopifi.com/md/glossary/liquidation-preference) above all. Delaware's corporation law lets a corporation issue one or more classes and series of stock with whatever preferences its charter sets, and lets it issue options to acquire its stock. An LLC has units and an operating agreement instead, which every investor document would have to be rewritten around.

> “Every corporation may issue 1 or more classes of stock or 1 or more series of stock within any class thereof, any or all of which classes may be of stock with par value or stock without par value”

— [8 Del. C. §151(a)](https://delcode.delaware.gov/title8/c001/sc05/index.html), Classes and series of stock — the statute preferred stock is issued under

> “Subject to any provisions in the certificate of incorporation, every corporation may create and issue, whether or not in connection with the issue and sale of any shares of stock or other securities of the corporation, rights or options entitling the holders thereof to acquire”

— [8 Del. C. §157(a)](https://delcode.delaware.gov/title8/c001/sc05/index.html), Rights and options respecting stock — the statute an option plan sits on

Incentive stock options, the employee options with the better tax treatment, are by statute options granted by a corporation, under a plan its stockholders approve. An LLC can't grant them.

> “the term “incentive stock option” means an option granted to an individual for any reason connected with his employment by a corporation, if granted by the employer corporation or its parent or subsidiary corporation, to purchase stock of any of such corporations”

— [26 U.S.C. §422(b)](https://www.law.cornell.edu/uscode/text/26/422), Incentive stock options are granted by a corporation, under a plan its stockholders approve

## QSBS

[Qualified small business stock](https://lopifi.com/md/glossary/qualified-small-business-stock) — which can exclude some or all of a holder's gain on sale from federal income tax — is by definition stock in a C corporation, originally issued, while gross assets are under the limit. An LLC's units never qualify; an S corporation's stock doesn't either. The holding periods and caps are the [QSBS explainer](https://lopifi.com/md/accounting/qsbs)'s and the [Cap tables & raising track](https://lopifi.com/md/learn/equity)'s.

> “shall in no event be less than the fair market value of the property exchanged”

— [26 U.S.C. §1202(c)(1), (d)(1), (i)(1)](https://www.law.cornell.edu/uscode/text/26/1202), Qualified small business stock is stock in a C corporation — and converted property starts the clock at conversion

## The investors' own taxes

A venture fund organized as a partnership can't hold S corporation stock. And if it invested in an operating LLC taxed as a partnership, the business's income would flow up to the fund's own partners — including tax-exempt investors, for whom a partnership's business income is unrelated business taxable income. A C corporation keeps the operating income, and its tax, inside the company.

> “If a trade or business regularly carried on by a partnership of which an organization is a member is an unrelated trade or business with respect to such organization, such organization in computing its unrelated business taxable income shall”

— [26 U.S.C. §512(c)(1)](https://www.law.cornell.edu/uscode/text/26/512), A tax-exempt investor's share of a partnership's business income is unrelated business income

## Delaware itself

Delaware's pitch, in its own words, is its statute and its court: the General Corporation Law, and a business court, the Court of Chancery, whose case law most corporate lawyers and investors already work from. The practical result is that standard financing documents assume a Delaware corporation.

> “The Delaware General Corporation Law is the most advanced and flexible business formation statute in the nation. The Delaware Court of Chancery is a unique, more than 225 year old business court that has written most of the modern U.S. corporation case law.”

— [Delaware Division of Corporations, About the Division](https://corp.delaware.gov/aboutagency/), Why businesses choose Delaware — in Delaware's own words

*[Figure: cap table]*

Northwind's two founders today, 4,000,000 shares each. A priced round adds a preferred-stock wedge and narrows theirs.

## What it costs

Delaware isn't free. Every Delaware corporation owes the [franchise tax](https://lopifi.com/md/glossary/delaware-franchise-tax) and an annual report by March 1, keeps a [registered agent](https://lopifi.com/md/glossary/registered-agent) in the state, and — because it works somewhere else — registers there as a foreign corporation and pays that state too. Northwind's charter runs through both franchise tax methods in the compliance track's [franchise tax lesson](https://lopifi.com/md/learn/delaware-franchise-tax-calculation).

*[Figure: delaware franchise tax]*

Northwind's charter in Delaware's franchise tax: authorized shares against assumed par value capital.

**Delaware C corporation**
- Pro: Preferred stock and option plans under the DGCL.
- Pro: Incentive stock options.
- Pro: QSBS for founders and early holders.
- Pro: The structure investor documents assume.
- Con: Double taxation of anything paid out.
- Con: Delaware franchise tax and annual report, on top of the home state's filings.
- Con: Losses stay in the company.
- Best for: A startup that will sell preferred stock, grant options and plan for a sale or IPO.

**LLC**
- Pro: One layer of tax.
- Pro: Losses pass through to the owners.
- Con: Conversion before the first priced round.
- Con: No ISOs, no QSBS until it converts.
- Con: K-1s for every investor.
- Best for: A business that will never take outside equity.

For a company that will raise venture capital.

> **Startups are Delaware C corporations because preferred stock, ISOs, QSBS and their investors' own taxes all require a corporation — and Delaware's law is the one the documents are written for.**

## Where this lesson's rules come from

- [8 Del. C. §151(a)](https://delcode.delaware.gov/title8/c001/sc05/index.html) — Classes and series of stock — the statute preferred stock is issued under (state)
- [8 Del. C. §157(a)](https://delcode.delaware.gov/title8/c001/sc05/index.html) — Rights and options respecting stock — the statute an option plan sits on (state)
- [26 U.S.C. §422(b)](https://www.law.cornell.edu/uscode/text/26/422) — Incentive stock options are granted by a corporation, under a plan its stockholders approve (statute)
- [26 U.S.C. §1202(c)(1), (d)(1), (i)(1)](https://www.law.cornell.edu/uscode/text/26/1202) — Qualified small business stock is stock in a C corporation — and converted property starts the clock at conversion (statute)
- [26 U.S.C. §512(c)(1)](https://www.law.cornell.edu/uscode/text/26/512) — A tax-exempt investor's share of a partnership's business income is unrelated business income (statute)
- [26 U.S.C. §1361(b)(1), (c)(4)](https://www.law.cornell.edu/uscode/text/26/1361) — Small business corporation: no more than 100 shareholders, eligible shareholders only, one class of stock (statute)
- [Delaware Division of Corporations, About the Division](https://corp.delaware.gov/aboutagency/) — Why businesses choose Delaware — in Delaware's own words (state)
- [SBA, Choose a business structure — Sole proprietorship, Corporation](https://www.sba.gov/business-guide/launch-your-business/choose-business-structure) — Personal liability without an entity, and why corporations raise money more easily (agency)
- [Wikipedia, “Delaware General Corporation Law”](https://en.wikipedia.org/wiki/Delaware_General_Corporation_Law) — Title 8, Chapter 1 of the Delaware Code, and why so many companies incorporate under it (reference)
- [Wikipedia, “Delaware Court of Chancery”](https://en.wikipedia.org/wiki/Delaware_Court_of_Chancery) — Delaware Court of Chancery (reference)

## Read further

- https://lopifi.com/md/journal-entries/issuing-common-stock
- https://lopifi.com/md/journal-entries/stock-based-compensation
- https://lopifi.com/md/startups/stock-options-409a-and-vesting
- https://lopifi.com/md/startups/how-to-account-for-safes
- https://lopifi.com/md/accounting/qsbs
- https://lopifi.com/md/accounting/83b-election
- https://lopifi.com/md/accounting/priced-round
- https://lopifi.com/md/accounting/option-pool
- https://lopifi.com/md/accounting/cap-table
- https://lopifi.com/md/accounting/delaware-franchise-tax
- https://lopifi.com/md/accounting/liquidation-preference

- **Track:** [Entity types](https://lopifi.com/md/learn/entities)
- **Lesson:** Lesson 4 of 9 — 9 min
- **Terms taught:** [C corporation](https://lopifi.com/md/glossary/c-corporation), [Qualified small business stock](https://lopifi.com/md/glossary/qualified-small-business-stock), [Liquidation preference](https://lopifi.com/md/glossary/liquidation-preference), [Delaware franchise tax](https://lopifi.com/md/glossary/delaware-franchise-tax), [Registered agent](https://lopifi.com/md/glossary/registered-agent)
- **Previous:** [Reasonable compensation, Entities · Lesson 3](https://lopifi.com/md/learn/s-corporation-election/reasonable-compensation)
- **Next:** [Converting an LLC to a C corporation, Entities · Lesson 5](https://lopifi.com/md/learn/convert-llc-to-c-corp)
- **The course:** https://lopifi.com/md/learn