One of the most common questions asked by startups is what kind of company should they choose to be. Whether to form as a limited liability company or a corporation (and then whether to be a C-corp or an S-corp) depends on many factors, none of which are, in truth, 100-percent dispositive. Within the same law firm, you will encounter lawyers who swear by LLCs and others who will, without fail, recommend an S-corp. So how do you decide? Here is how we think about it:
Do you want to be a pass-through entity? If you want the ability to claim profit or losses on your individual tax forms, then you want to be a pass-through entity. Typically, for companies likely to have great losses at the beginning (and the founders of which are putting in moderate to significant amounts of cash so they can take credit for those losses on their personal tax returns), a pass-through structure is advantageous. Similarly, for an entity expected to have very large amounts of profit at the beginning, avoiding a double taxation structure (one in which the corporation pays tax and then the stockholders pay tax on dividends) would be good. If you are interested in a pass-through entity structure, then either an LLC or an S-corp would be the right choice.
How will you be paid by the entity? Are you going to be receiving large amounts of cash from the entity? If so, as a member of an LLC, everything you receive will be subject to self-employment taxes. This means that, in addition to the typical Federal Insurance Contributions Act (FICA) and Social Security taxes you would pay as an employee, you would also pay the employer’s part (another 7.5 percent) of those taxes. If you do not anticipate receiving large amounts of cash at the beginning, then this will not make a huge difference to you. If, however, you are also going to be a W-2 employee of the company, then you may want to consider an S-corp. In an S-corp, your reasonable salary as a W-2 employee is subject to normal payroll taxes (meaning you pay employee-related taxes only on the W-2 income). All other dividends are subject to self-employment taxes.
Do you want to have different classes of equity? Many companies find that, over time, it makes sense to have stock or units with different economic and protective rights. Perhaps founders want to have equity with slightly preferential treatment when it comes to control of the company. Maybe your investors want some guarantee that they will get to take their money out first if there are distributions made in the sale or liquidation of the company. These rights are formalized into “classes” of equity. An S-corp is not permitted to have more than one class of stock (though there may be voting and non-voting versions of the same class). An LLC is permitted to have as many classes as it wants. If you think you want different classes of equity but want to make sure you still have pass-through treatment, then an LLC would be the right choice.
How many equity holders do you think you will have? An S-corp is limited to no more than 100 equity holders, all of whom must be either individuals who are U.S. taxpayers or certain trusts that are approved to hold S-corp shares. An LLC has no limits on either the number or kind of holders.
When do you think you will seek significant outside financing? The norm for venture capital investors has long been that those types of investors only want to invest in C-corporations. Because of their fund structures, many venture capital funds wish to make sure their limited partners are not subject to pass-through taxation based on the various investments made by the funds. This norm has been changing slightly and more and more venture capital investors are becoming ambivalent about the type of entity into which they fund, provided they still get the rights they want for their investment. That said, the market standard for this kind of investment continues to be the C-corp. Additionally, as angel investors become more sophisticated and begin forming their own angel funds, the traditional ambivalence of many angel investors is also being replaced by a preference for C-corporations. So, if you think you might seek investments from either angels or VCs in the next nine to 12 months, you may want to consider an S-corp instead of an LLC. That way, you can take advantage of pass-through taxation for the time up until you seek the third-party funding, and then you can “blow” your S-corp status automatically when you issue preferred stock to your angels or VC investors.
How do you want to govern your entity? Corporations are governed by their board of directors, with certain major decisions reserved for additional approval by the shareholders. The law in most states requires that board meetings are held on a periodic basis and that shareholder meetings are held at least once annually. All records of the board of directors and shareholder meetings should be kept in the form of minutes and resolutions and held in the corporation’s minute book. If you have a corporation and then are looking for investment or to be acquired, any potential investor or acquirer will want to review your minute book in addition to other diligence. Although many small corporations fail to properly adhere to the legal record-keeping requirements, it is a boost to both your value and your investors’ trust if you have good corporate records. Unlike corporations, LLCs do not have any legal mandates for either meetings or record keeping. This does not mean good governance practice is to ignore any record keeping; LLCs will find the same value and trust boost as their corporate counterparts if they keep records of significant decisions by their manager or board of managers and maintain some records of any meetings of their board of managers or members. In fact, because those records are not required to be kept, LLCs might see an even bigger boost in value and trust than their corporate counterparts, as they can show they are practicing good governance without being so required. Despite all this, if corporate record keeping is not your intention, then an LLC would be a better choice for you. If you plan to run a tight governance ship, then you will find either entity to be a good choice.
What happens if I make the wrong entity choice? With the range of questions that founders ask themselves about entity type, many worry they will make the wrong choice. Fear not. Every entity choice (LLC, S-corp, and C-corp) will provide you with the most important aspect of forming a business entity—and that is limitation of individual liability. It is critical to make sure you, the founders, are not on the hook for the debts and obligations of the company. While there is no entity that will completely protect you from your own gross negligence, willful misconduct, or fraud, the liability protections existing for all three types of companies are significant. Beyond that, it is a question of tax efficiencies, fundraising goals, and governance structures. And, if you need to convert your entity from a corporation to an LLC or from an LLC to a corporation, that is all allowable under the law. There may be some tax consequences of a conversion that you should discuss with your tax advisors and lawyers, but almost nothing is permanently set in stone—so get out there, form your company, and change the world!