Search Google for the best legal entity for your new startup, and you will get different opinions. Startup advisors and CPAs will probably recommend a limited liability company (LLC). That’s because an LLC isn’t subject to double taxation and is easier to set up.
On the other hand, many startup lawyers will recommend the C-Corporation structure (typically a Delaware C-Corp) because corporate law is typically more “stable,” equity (stock) ownership is passive, and the entity is more structured.
How you choose to incorporate your startup business will have massive implications down the road. This blog explores the basic advantages and disadvantages of each option.
What Is an LLC?
A limited liability company (LLC) is a simple and highly flexible business structure that offers the best of two worlds: the liability protection of a corporation and the ownership and governance flexibility like a partnership. In addition, LLCs are the most flexible entity with respect to taxes. An LLC, depending on the number of owners (called members) can be taxed as a sole proprietorship, partnership, S-Corp (assuming it meets certain requirements), or C-Corp.
Each State has an LLC statute. As such, LLCs will be governed by different rules and regulations depending on the State of Formation.
Advantages of LLCs
One of the most significant advantages of an LLC is its flexibility. All you need to get started is the Certificate of Formation (or Articles of Organization). The Certificate of Formation is a document that contains basic information about the LLC. The information needed varies from state to state. In Delaware, for example, you only need the LLC’s name and the name and office of the Registered Agent.
With the formation of an LLC, you get the following:
- Limited liability – An LLC protects its members and their assets from personal liability and lawsuits incurred by the company.
- Ownership Flexibility – An LLC is owned and typically managed by its member(s). However, an LLC can be managed by a single “Manager” or Board of Managers, who need not be [a] Member(s). An LLC can also have different types of ownership interests like voting and non-voting stock issued by a corporation.
- Tax flexibility – LLCs can opt to be taxed as a partnership, C-Corp, S-Corp, or disregarded entity (sole proprietorship).
Depending on the state where they are incorporated, LLCs also have limited compliance requirements and formalities.
Disadvantages of an LLC
Despite their attractiveness, LLCs have a few disadvantages:
- In some states, LLCs are subject to additional franchise tax (or partnership tax) charged yearly.
- LLCs may be restricted in how they can take on additional investment. Ownership interests are not typically passive like stock.
- LLCs are a relatively new type of legal entity. The first LLC statute was passed in 1977 (Wyoming). But most of the other States did not adopt LLC statutes until the 1990s.
- LLCs are mostly governed by contract law. LLC statutes are typically bare-bones and rely on the members of the LLC to establish the rules of governance (typically done through an Operating Agreement).
- Because LLCs are so easy to set up, many entrepreneurs use self-help websites like LegalZoom to form their LLCs. Without a corporate attorney asking the right questions, the business and operations of a new LLC can be doomed from the beginning.
LLCs are probably the most popular type of legal entity today. As such, many startup founders are attracted by the flexibility and freedom offered by the LLC structure.
What Is a Corporation?
A corporation is a separate and distinct legal entity from its owners in the eyes of the law, possessing many of the same rights and responsibilities as individuals. The law governing corporations is complex, and setting one up requires a Certificate of Incorporation, Bylaws, and various Director/Stockholder resolutions authorizing certain actions.
Shareholders own corporations. Shareholders elect the corporation’s Board of Directors, who typically make significant decisions on behalf of the corporation. The Board of Directors hires the Officers (CEO, CFO, Secretary, Treasurer, etc..), who typically run the day-to-day operations. In a closely held business, the Shareholders, Directors, and Officers are typically the same individuals.
S and C Corporations
S and C corporations are IRS designations determining how a corporation is taxed. Both are named under their governing sub-chapter in the Internal Revenue Code—C corporations under Sub-chapter C, and S-Corps under Subchapter S.
C-Corps are the “default” corporation, where the company pays a corporate income tax (currently 21% at the federal level; states differ), and the shareholders pay income tax from dividends (double taxation).
On the other hand, S corporations have pass-through taxation on distributions and are typically not subject to the same state and federal corporate tax. When forming an S corporation, you must file a special Form 2553 with the IRS if you meet all required guidelines.
Despite the stringent rules that manage the existence and operation of C-corporations, these entities have many benefits.
Advantages of Incorporating as a Corporation
The same rules that dictate how corporations are run also offer many protections and benefits.
- Limited liability – corporations are separate legal entities, and, assuming there is no fraudulent activity, the liability of shareholders is limited to the amount of money they have invested.
- Equity – assuming SEC/Blue Sky exemptions are met, private corporations can issue equity (stock/shares) to investors in order to raise capital, and also offer stock options to employees as a form of compensation. As mentioned above, stock equity is more passive than an ownership interest in an LLC as the shareholders are not considered “partners” for tax purposes.
- Corporate Law – since corporations have been around for a long time, the body of law governing their existence and operations is typically more stable than the law governing LLCs.
- Corporate Governance – while flexibility in the early days is usually preferred, as a company grows and more investors get involved, a fixed operational structure becomes paramount.
These features are especially important to investors, who prefer a passive investment and the straightforward management structure of corporations.
Disadvantages of Corporations
There are several disadvantages you need to consider before setting up your startup as a corporation.
- Control – at some point in the future, as you bring investors on board, you will be reporting to a board of directors who may not see eye-to-eye with you on every issue.
- Double taxation – your corporation will pay a federal and state corporate tax, and any distributions/dividends will also be subject to various taxes, which could hurt in the early days of your startup’s operations.
- Red Tape / Corporate Governance – As mentioned above, corporate formalities can be a benefit in the long run, but in the early days, rigid formalities, protocols, and requirements could hamper your business. If you forget a few director/shareholder resolutions, certain actions you’ve taken may not be technically legal under the corporation’s Bylaws.
Corporations are the most “trusted” legal entities today and are the entity of choice for Venture Capitalists and private investors. Many VCs will not invest in any other type of legal entity or require that you convert your LLC into a corporation before making an investment.
Get Help With Incorporating Your Startup
Finding the right legal structure to incorporate your business is a critical step, and there are many factors to consider. In addition to the factors above, the type of business you plan on operating can also play a role in the choice of legal entity. From investors to management, taxation, and your exit options, the LLC vs C-Corp choice is a tough one to make.
An experienced startup attorney can help you evaluate all these factors and give expert advice and guidance. Contact us today to learn more about which entity is right for your business.