Incorporating a business is the process of forming of a new entity that is recognized as a separate “person” under the law. At the very early stages of your business, you will be asked to decide which is the right business entity to form. Often this is overwhelming for founders and first time business folks. The three types of entities discussed in this article (C corporation, S corporation, and LLC) all partially shield the individual owners from certain types of personal liability. They each have varying benefits regarding fundraising and stock option grants, different tax implications, and provide your company with greater credibility among investors, clients, and customers.
Some Legal Implications of Incorporating:
- Partial protection against personal liability: A corporation or limited liability company (LLC) partially shields individuals (stockholders, directors and officers) from business liabilities such as loans, accounts payable, and legal judgments. We use the word “partially” because some courts have decided against completely shielding individual owners from personal liability, depending on their behavior and knowledge of the matter. On the other hand, the assets of the corporation or LLC may be protected if an individual is involved in a personal lawsuit or bankruptcy.
- Transferable ownership: Owners of a corporation or LLC may easily transfer ownership interests to others, depending on specific state requirements and their own company agreements or bylaws.
- Conversion: Depending on the rules of the applicable state statutes, one type of a business entity may be converted to another (for example, an LLC to corporation) and may even be converted to another state (i.e. from California to Delaware). Read a short Lloyd & Mousilli article on conversion if you’re considering starting with an LLC: LLC Now, Corporation Later?
- Taxation: Corporations are typically taxed at a lower rate than individuals. Corporations may also own shares in other corporations and resulting corporate dividends can be partially tax-free. If you have any doubts or want to explore tax questions, you should speak with a tax advisor. Our firm does not provide tax advice.
- Duration: Either an LLC or a corporation may continue indefinitely and beyond the lifetime of its owners.
- Raising capital: A corporation may raise funds by issuance of convertible debts and sale of stock. An LLC may raise funds by issuing membership interests.
- Employee incentives: A corporation may issue incentive stock options to employees as a form of compensation for their work and tenure. A similar structure may be created for an LLC, but it is typically more complicated and more expensive to manage and setup.
- Credit rating: A corporation acquires its own credit rating unassociated with the owner’s personal credit rating, even though the owner may be asked to provide some collateral or personal guarantee at times, especially early on after formation.
A C corporation is the standard corporation structure. An S corporation is a corporation that has elected special tax status with the IRS. Both of these corporate entity statuses share the following:
- They have shareholders, directors and officers.
- Both are required to follow the same internal and external corporate formalities and obligations, such as adopting bylaws, issuing stock, holding shareholder meetings, filing annual reports, and paying annual taxes and fees as required by state law.
- Articles of Incorporation are the same for both C and S corporations.
- Both C corporation and S corporation ownership is transferred by the selling of shares.
The advantages of C corporations are:
- Investors typically prefer this form of corporate structure when investing in accelerated growth tech companies due to multiple classes of stock available to C corporations, especially preferred stock. Preferred stock provides preferred returns and further protective provisions.
- C corporations are also a more favorable setup for employee compensation. A company creating incentive (via stock options) to attract and keep talented employees often prefer C corporation status. C corporations may allow employees to defer tax status on the equity compensation until they sell that initial stock by offering incentive stock option plans, variations of which are possible, but more complicated, in an LLC. Tax-free and tax-deductible benefits are also available to employees in a C corporation (again, check with your accountant on all tax matters).
- C corporations allow the owners to take advantage of certain provisions in the tax code with respect to exclusion of a certain amount of capital gains and the deduction of certain losses. However, please check with your accountant with respect to these benefits.
- Non-US citizens or and non-residents are permitted to be shareholders / founders of a C corporation.
- Since ownership is unrestricted, C corporations are often the best choice for large companies that are or plan to be publicly traded.
The disadvantage of a C corporation is double taxation:
- FIRST at the corporate level on the corporation’s net income.
- SECOND to the shareholders when the profits are distributed, if corporate income is distributed to business owners as dividends.
When a corporation is originally chartered by the state, it exists as a C Corporation. It will remain a C corporation unless the company wishes to elect S corporation status.
The main difference between a C corporation and an S corporation is the taxation structure. S corporations only pay one level of taxation: at the shareholder level. To choose S corporation status, a tax lawyer or accountant may assist with filing IRS Form 2553 and ensuring all S corporation guidelines are met. Since S corporation election is not required at the time of incorporation as a C corporation, a company may wish to momentarily hold off on S corporation election in order to consult with an accountant or tax lawyer.
Startup companies will choose an S corporation if the founders wish the benefit of a flow through tax treatment. In other words, a founder can include business losses on their personal tax returns as deductions, which may be particularly attractive during the early stages of a company. A startup can elect S corporation status before the financing stage and revoke S corporation status at the time of a financing. However, S corporation status prevents a startup from having entity (other corporations or LLCs) or non-US citizen/resident stockholders.
The disadvantages of S corporations, unlike C corporations, are:
- Limited ownership to 100 shareholders, who cannot be non-resident aliens, nor can S corporations be owned by other corporations.
- An S corporation cannot have multiple classes of stock.
- S corporations are not allowed to conduct certain types of business. Banks and insurance companies are not eligible for S corporation status.
- S corporations are less flexible than C corporations for employee fringe benefits.
- S corporations must report employee taxable compensation.
Limited Liability Companies – LLC
A limited liability company (LLC) blends elements of partnerships and corporate structures. An LLC is an unincorporated association that protects the liability of a company.
Startup companies often avoid LLCs because most technology startups seek to grant options to employees and consultants, and it’s very difficult to get professional investors interested in investing in an LLC. LLCs provide no standard or easy way to grant such options. A startup may convert from LLC status to a C corporation but, depending on the state, there may be statutory limitations or additional requirements in doing so. Consultancy and bootstrapped businesses, on the other hand, are often the best choices for LLC status.
Benefits of LLCs:
- Flexible management structure. Unlike corporations, LLCs are not required to comply with a formal management structure.
- Like the C corporation, LLCs have no ownership restrictions and members of an LLC may be non-US citizens and non-resident aliens.
- Flexible tax regime. An LLC can elect to be taxed as a sole proprietor, partnership, S corporation or C corporation. Using default tax classification, profits are taxed personally at the member level, not at the LLC level.
- LLCs can be set up with just one natural person (in some states) and thus partially separates the liability of a company from that member.
- LLCs can offer membership interests in the LLC to employees.
Disadvantages of LLCs:
- Investors may be wary of the LLC structure and prefer the traditional corporate structure of a C corporation or S corporation. This can make raising capital difficult for LLCs.
- Many states levy a franchise tax on LLCs, which is essentially the fee to pay for the privilege of the LLC status.
- Renewal fees may also be higher than a C corporation or S corporation.
- LLCs are not considered corporations for the purposes of civil procedure. Instead, LLCs are treated as partnerships by the courts. This affects diversity jurisdiction. Thus, if a member of an LLC is a citizen of the same state as a member of the opposing party, the LLC may not remove to federal court under jurisdiction (whereas the corporation can).
- The equity compensation process for employees is not straightforward and standard incentive stock options employed by C corporations are not typically available.
You should consult with the Lloyd & Mousilli team if you have any doubts at all about the appropriate entity type for your business.