What type of entity should I form?

March 12, 2009

C corps, LLCs, and S corps differ significantly in the areas of taxation, ownership, fundraising, governance and structure, and employee compensation.  Almost all technology startup companies that I work with are C corps.  Any company that raises venture financing will need to be a C corp in order to issue preferred stock.

If founders want the benefit of flow through tax treatment with respect to losses prior to an outside financing, an S corp election may make sense as long as there are no entity or non-U.S. citizen/resident stockholders.  However, S corp losses can only be used to offset personal income up to the founders’ basis in the S corp stock, which may decrease the utility of the S corp election. In any event, the S corp election can be easily revoked at the time of a financing. The legal documentation for an S corp is basically identical to an C corp.

I generally avoid LLCs as most technology startup companies need to grant options to employees and consultants, and there is no easy “off the rack” method to do this.  In addition, the conversion of an LLC to a C corp results in additional legal and accounting expense.  However, LLCs may make sense for businesses like consulting companies.

The primary differences between C corps, LLCs and S corps are outlined below.

Taxation

  • C Corps. A C corp is a separate taxable entity independent from its stockholders. Thus, the earnings of a C corporation are generally taxed twice: once at the corporate level on the corporation’s taxable income and a second time at the stockholder level on dividends or distributions. In addition, C corps often must pay higher state franchise taxes than LLCs or S corps.

Although the double-taxation feature of C corps may be undesirable, its impact may be diminished where a company does not pay dividends or generates taxable income at a lower marginal tax rate than the rate applicable to the individual stockholders. If a C corp generates net operating losses rather than net income, these are carried forward to offset future corporate taxable income. However, such operating losses may not be used to offset taxable income of the individual shareholders.

  • LLCs. LLCs are flow through entities for tax purposes, meaning that taxable income earned by the entity is passed through to individual members. Thus, earnings are taxed only once, at the member level. An LLC may elect to be taxed as a C corp, an S corp, or a partnership. It may specially allocate items of income or loss among its various members. It may use taxable losses generated at the entity level to offset taxable income of the individual LLC members. However, such flexibility is countered by increased compliance costs due to the application of complex partnership tax rules that also apply to LLCs.
  • S Corps. Similar to LLCs, S corps receive flow through tax treatment. However, an S corp must allocate its taxable income to the individual stockholders according to their ownership stakes in the company. Taxable losses at the entity level may be used to offset personal taxable income of the individual stockholders, but only to the extent of the tax basis of their interests in the entity.

Ownership (Stockholders)

  • C Corps. C corps may have an unlimited number of stockholders (subject to SEC reporting requirements if the number exceeds 500). The owners do not need to have a relationship with one another nor have a role in running the day-to-day affairs of the company. Additionally, they may transfer their ownership freely and readily (by selling their stock) without affecting the continuing existence of the business or the title to its assets. Thus, the perpetual existence of the entity is unaffected by the death or withdrawal of any one shareholder.
  • LLCs. Similar to a corporation, an LLC may have an unlimited number of members. However, ownership transferability for an LLC is not as flexible as that for a C corp. Generally, a member needs the approval of other members before selling an interest in the LLC. Also, a death, withdrawal, expulsion, or other departure of a member may constitute a termination of the LLC and a deemed liquidation for federal tax purposes.
  • S Corps. Unlike C corps. and LLCs, S corps are limited to 100 domestic stockholders. Stockholders must be individuals, with limited exceptions for certain trusts, estates, and exempt organizations. Stockholders must also be U.S. citizens or residents.  Ownership transferability is flexible and similar to that of C corps. Finally, the perpetual existence of the S corp is unaffected by the death or withdrawal of any stockholder.

Fundraising

  • C Corps. Most venture and institutional investors favor C corps because they may have separate classes of stock, allowing for the creation of various levels of preferences, protections, and share valuations. A C corp is also the easiest type of entity to take public in an initial public offering.
  • LLCs. Although LLCs may be attractive to businesses financed by a small number of corporate investors and/or individuals, they are often not suitable for companies planning to attract venture capital or pursue multiple rounds of funding. LLCs require complicated operating agreements that may render the operation of the LLC undesirably difficult with a high number of members. They may be unattractive to tax-exempt venture fund investors because their investment in a flow through entity may produce unrelated business taxable income. Finally, investors simply may be less familiar with LLCs and therefore less willing to invest in them.
  • S Corps. S corps are not a popular entity choice because, in addition to presenting the same challenges to tax-exempt venture fund partners as those presented by LLCs, S corps are limited to one class of stock (meaning no preferred stock financings) and 100 stockholders. Such inflexible features are typically unattractive to venture investors.

Governance/Structure

  • C Corps. C corps have well-defined structural accountability, with governance responsibilities held separate and apart from the owners. Management is accountable to the board of directors and therefore has the ability to transact business without stockholder participation in each decision. However, corporations are required to pay attention to formalities that legislatures and courts have determined to be significant (e.g., meetings of boards of directors and maintenance of corporate bylaws, corporate minute books, stock ledger books, separate bank accounts, etc.).
  • LLCs. LLCs operate more informally then C corps and are either managed directly by the owners or managed by one or more owners (or an outside party) designated to fulfill such responsibility. Unlike corporations, they are not bound by corporate formalities such as holding regular ownership and management meetings. However, in contrast to corporations, they do not operate under a well-defined regime of uniformity and legal precedent.
  • S Corps. S corps operate in a manner similar to C corps. and must therefore adhere to statutory formalities for decision making.

Employee Compensation

  • C Corps. Businesses that plan to use equity incentives (e.g. stock options) to attract and retain talent often prefer to operate as C corps. C corps can offer incentive stock option plans that allow employees to defer tax on the equity compensation until they sell the underlying stock. Additionally, C corps. may offer certain fringe benefits to employees that are tax-deductible to the company and also tax-free to the employee.
  • LLCs. While an LLC may reward employees by offering them membership interests in the LLC, the equity compensation process is awkward and may be unattractive to employees. Furthermore, LLCs are not able to offer certain forms of equity compensation available to C corps., such as incentive stock options.
  • S Corps. Although S corps can grant stock options, they should not be granted to non-U.S. residents. S corps are less flexible than C corps with regard to fringe benefits and must either report the benefits as taxable compensation to the employees or forfeit the fringe benefit deduction available to the company.

Comments

  • http://michaelbungartz.wordpress.com Michael | eVenture Today

    Just came across your blog. Great stuff here. I look forward to following your articles and stopping back to look around a bit.

    Regards, Michael

  • http://www.everythingrandom.net Stephen

    very well written, lots of good info to consider

  • Shahril Anwar Mohd Yunos

    Can a LLC be solely owned by a foreign entity (non-US company) that will be used as a vehicle for investment purposes in US startups?

  • http://www.startupcompanylawyer.com Yokum

    @Shahril – Yes. However, the typical venture fund structure involves a General Partner entity as an LLC and an investment entity as an LP.

  • Adam

    I currently have a partnership that I operate, however, I am looking to change to a corporation. I do not want to be taxed on my inventory as income. Currently I haeve to claim inventory as income on my tax returns. Which entity would you suggest for me? Are S Corps and LLCs treated the same in this regard?

  • http://www.startupcompanylawyer.com Yokum

    @Adam – please go ask your accountant.

  • Smith

    Great article! What entity would you suggest for a start-up clothing line?

  • Pingback: Incorporation : Resources | Launch a company

  • pdonovan

    Hello Yokum/SCL and Others,

    For initial non-VC deals, or ~90% of US tech start-ups outside the valley (?), I vote for the LLC.

    I have reviewed the comments on this site and have additional references and comments for those interested.

  • drewzerd

    pdonovan- Thanks. I'm currently drafting an LLC operating agreement for a software company (non-VC funded) and would love to read your comments.

  • drewzerd

    pdonovan- Thanks. I'm currently drafting an LLC operating agreement for a software company (non-VC funded) and would love to read your comments.

  • cfoquest

    Have start up. Thinking LLC is best; no VC exit is expected. Biggest opportunity of the Preferred owners is rights to liquidation and distributions. Question: can California LLC have multiple classes of stock (can it have preferred stock)? Thought so, but am getting conflicting advice.

    Also, assuming LLC makes sense, can restricted stock structure work (can an employee make an 83(b) election??)

  • Davidson

    @Yokum, thanks for such an in-depth explanation. You say that reincorporating to convert an LLC to a C corporation will incur additional legal and accounting expenses, but on what magnitude are we talking here? Thousands of dollars, tens of thousands of dollars, or hundreds of thousands of dollars? Obviously you can’t provide an exact figure, but a ballpark amount for a typical situation would be helpful.

    To clarify why I’m asking, say I have a startup which is not taking any outside capital at the outset, but which may in the future and thus will require being a C corporation at that point. The relative cost between forming an LLC and a C corporation at the outset is (say) $1,000 vs. $2,000. At the beginning that $1,000 saved is very important for cashflow purposes. If it will only cost $5,000 down the road to convert the LLC to a C corporation, the $1,000 saved in the beginning could be more valuable than the $5,000 cost later. But if the cost is $75,000 later, it might not make as much sense to save the $1,000 up front.

  • http://www.startupcompanylawyer.com Yokum

    @cfoquest – A CA LLC can create multiple classes of ownership interests that mimic the rights of preferred stock. However, this is a custom document and require significant attorney time. In addition, holders of LLC membership interests subject to vesting in connection with services may file 83(b) elections.

  • Tammy

    If an LLC wanted to form a subdivision for a specific project and have investors for the project alone, how would they go about doing that?

  • TallTex

    I do not know how you can in a traditional LLC. However, if you are in one of the 8 States that have Series LLC then you may. Each series in a Series LLC may have different managers and members from other series in the LLC. For example you have the ABC, LLC, in my case a TX Series LLC, Series-A owns patents, trade secrets and other IP. Series-B owns most of the manufacturing equipment, Series-C owns the company's cash reserves and other “non-risky” assets, Series-D owns a seperate operating business with its own manager and memebers. The goal is for all risky assets to be owned within its own series and segregated away from each other and the company's safe assets. Even in a strong asset protecton state such as mine I would never advise a corporation to own significant assets or for any entity to “co-mingle” assets in the same pool.

  • Mich

    Currently have LLC, one manager, all three investing in start-up no FFFs, percentages determined, OA in place and all in agreement. Works fine now. I am concerned LLC will pose a problem later (sooner than later) when AF or VC desires to invest. Should we become C-corp before valuation becomes higher. Gut feeling tells me LLC will eventually be a problem or rejected by outside investors…and I can not get a straight answer from qualified attorney. Simple solution now or difficult and distracting problem later….

  • http://www.startupcompanylawyer.com Yokum

    @Mich – You need to consult with an attorney who can confirm that the LLC conversion will be tax-free in the future based on your facts. Venture funds and silicon valley angels will not invest in an LLC. I never incorporate LLCs if the company needs outside financing or needs to grant options to employees.

  • Noopdaddy

    Hi David : Did you get answer to your question?

  • Noopdaddy

    We are a group of three people (2 US permanent residents and one US citizen) who are about to launch a website, very similar to Craigslist. We do not need any money now from angels/VCs but if the site takes off we might in the future. Questions:
    1. Should I go for LLC or S Corp or C corp. Minimizing the cost of incorporation is a big factor for us but I am willing to override if it will cause us exorbitant fees of conversions later.

    2. If we go for LLC, should we go ahead and incorporate in Delware because that seems to be cheapest. I live in California. Will I still have to pay some taxes to CA since I live in California and hence doing business in California although I incorporate in delware? Also since its a nationwide listing website, I will be doing business pretty much anywhere in US!!
    3. Whats the rugh order of magnitude difference in incorporation cost of LLC versus C corp versus S corp.
    4. Whats the rough order of magnitude difference in minimm taxes for LLC versus C corp versus S crop, assuming that for the first year we will have almost zero revenue and some costs.
    5. If I cannot get clear answers to these questions on this website for free, who can tell me a good laweyer in bay area who will give me clear answer without charging me a LOT.

    I am sure a lot of technology start up have same questions when they start. I hope somebody is able to help me out here.

  • Hturko

    Have you considered Wyoming?

  • http://twitter.com/xandavie Alexander Davie

    Why don't you form another LLC and have your main LLC be an owner in the new LLC along with your investors.  Essentially you'd be duplicating the limited partnership structure used by most investment funds.

  • amitcv

    Noopdaddy,
    I'm assuming you got answers to your questions (or figured them out by now) – I have the same challenges – would love to get your perspective.
    Thanks