Posts Tagged ‘Startups’

Which Is Better for My Startup, C Corporation or LLC?

Monday, September 13th, 2010

Photo Courtesy NASA’s Marshall Space Flight Center

Startup clients frequently ask– which is the better business entity, a C corporation or a limited liability company (LLC)?

Before answering that question, let’s quickly review the basic differences between C corporations and LLCs. (For more detailed treatment, see here.)

In a corporation, control is held by the shareholders, but they frequently delegate most major decisions to the board of directors and day-to-day control to the officers. The corporate entity shields shareholders from the corporation’s liability and income. But if the corporation’s income is distributed to the shareholders, for example as dividends, the income is effectively taxed twice, once at the corporate level, once at the shareholder level. The corporate entity is especially advantageous for allowing changes in ownership– in the absence of special provisions such as shareholder agreements, existing shareholders can buy and sell stock without restriction to new shareholders.

Pros

  • More “professional” image
  • More attractive to venture capital funding and more flexible for granting options and other incentive compensation
  • Easier to take public

Cons

  • More formalities such as required shareholder and directors meetings, capital maintenance, etc.
  • Income to shareholders is taxed twice

The LLC is a relatively recent creation, within the last 25 years in most states. It is based on the partnership model, where partners share all control, income, and liability personally. Like partners, LLC “members” share control and income, but like corporate shareholders, members are shielded from liability for the acts of the LLC. LLC income is taxed only once, but all profits (and losses as well) are attributed to the members, even if the LLC retains it and does not distribute it to the members, as frequently occurs in the startup stage. (Note that an LLC can make an election with the IRS to be taxed like a corporation, while a corporation can make an election with the IRS to be taxed like a partnership, as a so-called S corporation.) However, as with a partnership, an LLC does not easily release old members or admit new members– the default rule is that normally at least a majority of existing members must approve any change in membership.

Pros

  • Inexpensive and easy to set up and maintain
  • Income to members only taxed once (but all of it is taxed, even if not distributed)

Cons

  • More difficult for old members to leave, and new members to join (may be a pro for some startups)
  • Disfavored by venture capitalists and incentive recipients
  • Must be converted to a C corporation to take public

Bottom Line: if VC funding and/or publicly listed stock is part of your business plan, then a C corporation is your best startup entity. In almost all other cases, an LLC is cheaper, easier, and lower maintenance, but be sure to address your exit strategy, both for individual members and the company as a whole, in your LLC documents at the startup stage. To help you make the correct choice, please consult a knowledgeable business attorney and/or accountant.