Let’s face it, the type of entity you use for your new business can have monumental consequences that reach far beyond the paperwork. It’s worth it to get it right from the start! Let’s dive in, so that you can start your business on the right foot.
The letters LLC stand for “Limited Liability Company.” Limited liability is, in my opinion, the greatest legal technology out there. It allows all of us to invest some (limited) resources into a venture, and if that venture doesn’t work out, or if something terrible and unexpected happens to it, our liability is limited to the value of the company itself.
For example, let’s say I opened up an ice cream store, worth around $30,000 after the first year, and someone dropped their ice cream on the floor, which caused a wealthy surgeon to slip and fall, knocking her head tragically on the hard concrete floor, causing death. The surgeon’s estate would most assuredly sue my ice cream store for “wrongful death,” and the damages could be in the 5 million dollar range. Thankfully, that liability is limited to the $30,000 the store is worth. My other assets are not at risk. That’s limited liability.
LLCs as an entity type were created in the early 90s. They streamlined limited liability more than their major predecessor, the Corporation, which we get into below.
A C Corporation was the original limited liability entity type, created around the Industrial Revolution. The advantage to this entity type is that it remains the sort of go-to, or gold standard, when it comes to forming a business. However, the drawback is that the laws that gave us Corporations remain largely outdated and archaic by today’s standards. There’s a plethora of administrative red tape that we have to deal with in order to maintain a Corporation. In contrast, LLCs require very little maintenance.
While C Corporations were very innovative for their time (the 1800s) I think the lawmakers didn’t want most people to have access to limited liability, so they created a great deal of administrative to-do items and requirements, which served a sort of gatekeeping function.
Practically speaking, ownership of an LLC and a Corporation normally work out the same, or at least very in similar ways, but the names for things are different. For a Corporation, ownership is denoted by “stock” in the company. For an LLC, ownership is called “Membership Interest Percentage.” There are some cool things we can do with Corporate stock that we can’t always do with LLCs, such as creating multiple classes of stocks, but that’s not normally done and can be done for an LLC if you’ve got an experienced attorney.
The default management structure for corporations is normally a Board of Directors, or BoD. These directors can own company stock, but they don’t have to in order to serve on the board. In modern corporations, for smaller and closely held businesses, however, a traditional BoD is rare. The management structure would normally be laid out in the “Corporate Governing Documents or Binder,” and more specifically, the “Shareholder Agreement.”
For LLCs, there’s usually a single manager (the “Managing Member”) that makes most day to day managerial decisions and leaves the bigger decisions up to a majority vote of the owners. Or, the LLC could be managed by all the members (the owners all get to participate in the management of the company). These are called “Member Managed” LLCs, and are a common structure. Typically, the managerial powers and structure are laid out in the LLC’s “Operating Agreement” which an attorney would write when the business is first started.
Taxes are where the entity types differ a great deal. LLCs have what is called “Pass Through Taxation,” where the owner’s personal tax returns include profits from the business. In contrast, Corporations have what is called “Double Taxation.” The Corporation itself is taxed first, on the profits it makes. Then, if and only if, the Corporation distributes profits to its owners, the owners are also taxed (a second time) on their personal tax returns for however much profit was distributed to them. Normally, double taxation results in giving more tax money to the government, but not always (there are some funky examples that would take us beyond the scope of this article).
Importantly, though, LLCs are allowed to be taxed as if they’re a C-Corp or even an S-Corp, if the owners so choose–the IRS doesn’t really care how you’re taxed as long as you’re paying taxes. It is often the case that S-Corp taxation results in less taxes overall, and LLC owners want to switch the way they are taxed from the default style to the S-Corp style. This just takes hiring a good CPA who knows what they’re doing.
With modern legal technology, there’s not a major difference for funding between an LLC and a C Corporation. An experienced business lawyer can pretty easily navigate you through whatever funding structure(s) you or your investors need.
That said, there are some investors that demand to invest in a C (or S) Corporation, because that’s been their experience for decades and they don’t want to have to figure out LLCs. This is getting more and more rare, as investors understand the streamlined value of LLCs, but I still see it from time to time. If that’s the case, it is doable to convert an LLC to a Corporation; you just need an experienced legal team to pull it off correctly.
We touched on this earlier with taxation, but we’ll be a little more specific here: LLCs, by default, are taxed as if all of the company’s profits are immediately distributed to the owners (even if the owners don’t actually receive that money in their personal bank accounts). This is largely for simplified tax and accounting purposes. It can create what we call a “cash crunch” sometimes, so make sure to discuss with your CPA things like anticipated cash flow and tax liability.
That all said, LLC owners are allowed to just withdraw money from the company’s bank account and plop it into their personal account (unless they take so much out that the company can’t pay for what it owes). Similarly, Corporations need the managers (Board of Directors or the stock owners) to make a vote to do a “profit distribution” to the shareholders (owners) at whatever intervals makes sense for them. You can probably see, from reading this, that Corporations are more involved and difficult to manage when it comes to things like this.
9 times out of 10, LLCs are better for startups than corporations. The only real time that I see that differently is when the startup has a lot of investors that want to invest very early on, and want or expect the company to take off quickly, and even get to a major stock market in the near future (such as the Nasdaq or the New York Stock Exchange). Normally, for a company to be traded on the public stock exchange, it has to be a corporation.
Still, a successful startup LLC can convert later on to a corporation if it needs to.
Pros for LLCs are that they’re less costly than corporations simply because you don’t have to hire lawyers to do all of the compliance stuff you need for corporations. LLCs have easier “pass through taxation” by default, and don’t require much ongoing annual maintenance. They’re normally cheaper to set up, as well (we charge about 40% less to set up new LLCs than we do for new corporations because the legal work involved is significantly less).
The drawback for LLCs is that they’re a little less flexible. That’s the tradeoff for the simple streamlined structure of LLCs. Corporations have been the gold standard for around 150 years now, and courts and lawyers have had plenty of experience dealing with problems that arise. All of these problems are solvable; they’re just expensive and time consuming.
This is basically the opposite of what we said above for LLCs. Corporations require a great deal of initial legal work (organizational meeting minutes, stock ledger, bylaws, shareholder agreement, stock issuances and stock grants, etc.), and these documents take a lot more time and effort for lawyers to draft than the simple operating agreement that LLCs require. Corporations also require “annual meeting minutes” which is a formal record of meetings among the shareholders and/or Board of Directors that goes over the business of the corporation. If you miss a year of these annual meeting minutes (which business owners are apt to do) then it gives plaintiffs an argument that you’re not “respecting the corporate form” and the judge should “throw out your limited liability” and allow them to sue the owners personally. As we saw in our above example of the ice cream store and the surgeon, this would be very costly!
The pros for corporations over LLCs are that:
I’m just going to list out some things to think about:
Setting up any company is fraught with landmines. It’s worth its weight in gold to have a professional business formation attorney set up the company for you; get it right from the start! At Sparks Law, helping new entrepreneurs with their startup businesses is one of our favorite things we get to do. We love your ideas and respect the courage it takes to make that first step! Feel free to reach out to us to start building your business.
