Entity Formation (Part 2 of 3): Selecting the Form of Entity
You have decided to establish an entity, but now you must decide which one is best for your company. For most technology startups, the three relevant choices are an LLC, a C-corporation, or an S-corporation.
Limited Liability Company (LLC)
A limited liability company is sometimes described as a hybrid between a general partnership and a C-corporation. It will protect against personal liability like a C-corporation, but it has pass-through taxation like a partnership.
Limited liability: Unlike a partnership, the members of the LLC can control and manage the company without being subject to personal liability.
Pass-through taxation: Unless an LLC elects to be taxed differently, the LLC’s income will be taxed only at the member level. This means earnings will be taxed on the individual member’s personal tax returns. It also means that losses can be used to offset individual member’s income (up to the amount of capital the member has contributed to the LLC). This kind of taxation may be favorable to a C-corporation’s double taxation.
Flexibility: An LLC is an incredibly flexible entity, and can be formed to operate in almost any way the owner chooses. These choices will be reflected in an operating agreement. For example, owners can run the company like a corporation with a Board of Managers and officers, as a manager-managed LLC with certain members managing other members, or as a member-managed LLC with all members acting as managers and having similar powers and authorities. As mentioned, an LLC also has the ability to elect different ways to be taxed (as a partnership or a corporation), and it is not subject to the same formalities as a corporation (i.e., they are not bound to hold regular meetings and take minutes as a corporation is). Agreements can also set up different profit/loss sharing than the voting power, where a corporation’s profits/losses and voting power are set by their ownership percentage (unless they have different classes of stock).
Cost: To set up an LLC in Michigan, the filing fee is only $50, and the annual fee is only $25. This is generally much less than it will cost to set up a corporation and maintain the annual fees.
Employee compensation: If members of the LLC are to be paid a salary, it will be subject to a self-employment tax unlike a corporation which can write off salaries as a business expense. LLCs also do not have the ability to offer tax-advantage employee stock options (ISOs), and it is more complex and difficult to offer the equivalent of stock options to their employees.
Complexity: The flexibility of an LLC also makes it more complex, and makes the set-up process more difficult because it does not have the defined structure of a corporation. While LLC members do not need to create an operating agreement in order to be considered an LLC, it is crucial that you do have one, especially if you have multiple owners. Partnership taxation is also more complex than corporate taxation.
Funding: An LLC typically cannot raise money from institutional investors, who will not invest in a pass-through taxation entity. Angel investors also do not like LLCs as much as C-corporations because they are less familiar with them and because of the limitations for future rounds of fundraising.
Ownership transferability: Ownership is less transferable than in a c-corp. Often, members need approval of other members before they sell their interest, and sometimes death or other departure of a member may cause the LLC to terminate (these are terms that can be further laid out in your operating agreement).
Like an LLC, with a C-corporation, personal liability of owners is limited because the corporation is a separate entity. Unlike an LLC, though, a corporation is taxed as a separate legal entity, and thus may be subject to double-taxation if profits are distributed to shareholders.
Taxation: Though a corporation is subject to double taxation, the double taxation will only occur if profits are distributed to shareholders (e.g., if the corporation issues dividends). It is extremely rare for an early-stage technology startup to issue dividends. Also, if the corporation makes less than $50,000 the corporate tax rate is only 15%, which is often lower than an individual’s tax rate, and thus the taxes on the corporation may be less than the individual rate of LLC members. Corporations are not subject to self-employment tax and can write off wages as an ordinary business expense (up to a certain limit). Taxes are also less complex and more certain than an LLC.
Limited liability: Because a corporation is a separate legal entity, it is subject to legal liability as a legal entity. This helps protect against personal liability.
Transferability: Shares in a corporation are freely transferable without affecting the existence of the business or title to the assets. Although, for most startups, the transferability of shares is limited under the terms of industry standard restricted stock purchase agreements.
Funding: Investors are most willing to invest in corporations, and for certain investors (like VCs), a c-corporation is the only entity they are willing to invest in.
Double taxation: When profits are distributed to shareholders, the profits will be taxed twice: once at the corporate level, and once at the individual shareholder level. If the corporation is reaching a certain level of profits, it will be taxed at a rate of 35%, the highest tax rate for individuals. When profits are distributed, those profits are taxed again.
Cost: The filing fees to set-up a corporation can be much more expensive than an LLC. In Delaware, the minimum filing fee is $89 (more for extra pages and based on amount of stock the company will have), and the annual fee is $50/year. Depending on the way you choose to be taxed, there is either a minimum of $75/year or $350/year in taxes.
Administrative burdens: There are more formalities to a corporation, and thus there are more rules to follow. For example, a corporation must set up a Board of Directors who must have annual meetings and take minutes. In Delaware, a company can avoid the annual meeting through a written shareholder consent. But, this also requires paperwork and communication with shareholders that most states do not require for LLC’s. There is more record-keeping for a corporation than an LLC.
Ownership: Voting power and profit/loss sharing is set by the ownership percentage, and is thus a less flexible form than the LLC. Ways to get around this are by creating multiple classes of stock with different voting powers allocated to each class.
An S-corporation is a corporation that elects to be taxed as a partnership (pass-through taxation). However, there are only certain kinds of corporations that can make this election, so it is more limited than a C-corporation.
Limited liability: same protections of the C-corporation.
Transferability: same favorable treatment of the C-corporation.
Pass-through taxation: same favorable treatment as an LLC.
Conversion: Converting to a C-corporation is very simple because you already have all the requisite documents and filings in place with the state. Converting from an LLC can be much more difficult and expensive. If you know you are going to need to be a C-corporation for funding purposes at some point, but want the favorable tax treatment of an LLC in the meantime, it might be a good idea to set up an S-corporation (if you meet the requirements) in the mean time so conversion is a simpler process.
Cost: same burdens associated with a C-corporation set-up.
Administrative burdens: same burdens associated with a C-corporation.
Limitations on ownership: An S-corporation is limited to 100 shareholders who must be US residents, estates, or some trusts and partnerships. S-corporations can only have one class of stock (which means you can not have voting and non-voting classes). Accordingly, only certain kinds of businesses will meet the requirements to elect this status. This also precludes an S-corporation issuing a preferred class of equity and therefore raising venture capital.
Overall, there are a lot of considerations that go into deciding which corporation you wish to set up. Among these, financing choices is usually one of the biggest driving forces. If you wish to pursue venture capital, a C-corporation is essentially a must. Talking to an attorney and an accountant about these considerations is usually the most effective way to make a decision.