Startup owners face a lot of decisions, but one of the most important they will make is which type of entity to form, whether it be a C Corporation, an S Corporation or an LLC. Which one you choose will affect a number of things, including what you pay in taxes, your ability to raise investment money and employee compensation.
Here is a look at some of the main differences between the different types of business entities.
Taxes
An LLC has complete flexibility on how it wants to be taxed, it able to choose to be taxed as a partnership, as a C Corporation or as an S Corporation. As a partnership, it is treated as a flow through entity, which means its taxable income is passed through to individual members and the entity itself is generally not subject to income tax. The LLC can use taxable losses generated at the entity level to offset taxable income of the members. One disadvantage is that LLCs are subject complicated partnership tax rules, which can lead to increased compliance costs. Further, all income will likely be subject to employment-related taxes for active members.
Similar to an LLC, the S Corporation designation allows flow through taxation, meaning no corporate tax. Individual shareholders pay federal income tax on the taxable income of the S Corporation’s business based on their pro-rata stock ownership. Taxable losses at the entity level can be used to offset the shareholders’ taxable income, but only to the extent of the tax basis of their interests in the entity. A benefit of the S Corporation over the LLC is that only the “reasonable salary” of the owners is subject to employment-related taxes.
C Corporations are what people usually consider “regular” corporations that are subject to a corporate income tax. It pays taxes on net income, that is income after expenses and salaries. Shareholders also pay tax on dividends or distributions, so in effect the money is taxed twice, both at the corporate and shareholder levels. In addition, C Corporations often pay higher state franchise taxes than LLCs and S Corporations and can be somewhat more costly to maintain from a legal and tax filings perspective.
Being subject to a “double tax” can give some owners reason to pause when considering whether to become a C Corporation. However, it is unlikely that entities planning to raise venture capital or money from angel investors will pay dividends and the downside of the double tax can be diminished if the company reinvests its surplus cash in order to grow. In addition, the C Corporation can accumulate net operating losses, which can be carried forward to offset future corporate taxable income.
Flexibility of Ownership
C Corporations are not limited in terms of ownership participation, meaning they are able to have an unlimited number of shareholders and virtually any type of owners. The owners can sell their stock without affecting the business’ existence. Also, the company is not affected by the death or withdrawal of a shareholder. In contrast, S Corporations can only have 100 shareholders and they must be U.S. residents or citizens. With limited exceptions, the shareholders also have to be individuals.
Like Corporations, LLCs enjoy the ability to have an unlimited number of members. Unlike C or S Corporations, the departure of a member can constitute a termination of the LLC and a deemed liquidation for federal tax purposes, unless otherwise agreed by the members.
Raising Money
If a company wants to issue convertible preferred stock, which is the typical vehicle for a venture capital investment, it needs to be a C Corporation. That’s because C Corporations can issue separate classes of stock, which allows for the creation of different levels of preferences, protections, and share valuations.
S Corporations are only permitted to have one class of stock, precluding them from issuing preferred stock. And a venture capital fund can’t invest in pass through companies – either S Corporations or LLCs – if it has tax-exempt partners that can’t receive active trade or business income because of their tax-exempt status.
This is part of the reason venture capitalists typically are unable to invest in LLCs. Also, investors often don’t want to become a member of a business that is taxed as a partnership because it can result in them being taxed on the business’s income, even in years the investor doesn’t personally receive any distributions from the company.
Business Operation/Structure
C Corporations and S Corporations operate in a similar manner, with a well-defined structure in which a board of directors handle management responsibilities and corporate officers deal with day-to-day operations. With limited exceptions, the shareholders remain separated from the business decisions of the corporation. The corporate classification has been around for decades, to the point that laws for the corporate form have become, for the most part, uniform. Courts also have a good deal of case law with which to rely upon in resolving disputes. Along those same lines, corporations have to pay attention to certain formalities (holding regular ownership and management meetings, maintenance of corporate bylaws, etc.) that courts and lawmakers have determined over the years to be important.
LLCs can have a more centralized management structure and operate more informally than corporations. Any member can act as the LLC’s manager and the LLC can choose not to have any distinction between an owner and a manager. LLC’s aren’t required to adhere to the same corporate formalities as S and C Corporations. But LLCs, which are relatively new compared to corporations, also don’t operate under the same well-defined regime of legal precedent. States, for example, can differ in some respects to their treatment of LLCs. So, at a minimum, I generally recommend LLCs operate with the same formalities as corporations.
Employee Compensation
Many startups want to have stock options and other equity incentives for their employees. This is generally much easier to do with a corporation. While an LLC can offer membership units to employees, the tax consequences and regulatory issues are often complex and can be a burden. Please see another post I wrote regarding equity incentives for LLCs and other partnerships for a more detailed discussion on this issue.
C Corporations are able to offer incentive stock option plans that give employees the ability to defer tax on the equity compensation until the underlying stock is sold, as well as fringe benefits that are tax free for the employee and tax deductible for the company. S Corporations are less flexible with respect to fringe benefits. They must either report the benefits as taxable compensation to the employees or forfeit the available fringe benefit deduction.
Conclusion
When startup clients ask which business entity they should choose, I typically advise them to go with a C Corporation if the goal is to be venture backed. Generally speaking, this is the best route if you are going to be raising money from third parties. This is in large part because the other structures can present inconveniences to future investors. Also, investors typically have experience working with C Corporations and are comfortable with their governance and taxation. This familiarity is such a benefit that some won’t seriously consider investing in other types of entities. However, if the business is meant to be a cash cow for the founders and outside capital isn’t going to be pursued, I’d go with a S Corporation if the lack of flexibility isn’t going to negatively affect the founders’ goals. Otherwise, I’d generally go with an LLC. But, it isn’t a simple issue, so the founders should always consult with a qualified corporate attorney to assist them in making this important decision.
