One of the first questions to address during the startup process is whether to incorporate as a limited liability company (LLC) or corporation. Both entities provide the benefit of liability protection and the ability to issue equity to investors and service providers.
But these entity type have different strengths and weaknesses depending on the specifics of your business.
Below are the key factors when choosing between these two corporate forms:
Taxation. LLCs are taxed as pass-through entities, which means they are not taxed at the entity level. This enables the distribution of profits to owners on a tax-free basis. Of course, owners still have to report the profits on their personal tax return but the LLC itself does not pay tax on those profits. Likewise, this enables the pass-through of losses, which, especially in the early stages of a business, can be advantageous to founders who are bootstrapping or raising capital through debt and have other income to offset. Some of these advantages can be secured through a corporation electing to be taxed as an “s corporation.” But maintaining that election comes with restrictive requirements - such as limits on the classes of stock and shareholders - that aren’t suitable for growth-oriented companies. Corporations, on the other hand, enable the carry-forward of losses and the issuance of qualified small business stock, which have significant tax advantages. In short, analysis of the tax implications can involve a wide range of considerations particular to your business plans and objectives.
Capital Raising. Many institutional investors are prohibited from investing in pass-through vehicles like LLCs or have strong preferences against them. For this reason, companies planning to seek institutional growth capital often incorporate as or convert into corporations.
Equity Compensation. Both LLCs and corporations can issue equity to service providers but corporations can generally do so more efficiently. While LLCs can issue options, they cannot issue incentive stock options, which are tax favored options for employees. Because LLCs are generally taxed as partnerships, when they issue equity interests to team members, they must issue K-1s to recipients and maintaining capital accounts for them. The tax complexities can multiply quickly.
Flexibility. While corporations are highly efficient, LLCs are highly flexible. The governance and ownership structure of an LLC is largely determined by the contract among its owners, giving the parties latitude to accommodate different business needs and scenarios.
Legal Predictability. Corporations are the most well-established legal form for the conduct of business. Corporate governance matters and the legal principles that apply to them are well developed, providing important predictability and guidance in the conduct of a business.
For emerging growth companies with the clear intention to raise institutional capital and scale with large teams, formation of a c-corporation is almost always the most efficient and effective legal entity for the job.
For others, the choice of entity can be a more complex and nuanced decision. We always advise making the choice of entity decision in consultation with legal and tax advisors based on the specific plans for your business.