When starting a new business, there are many legal and tax considerations for choosing the best structure. Registering your new company tells the government how you want it to view and tax—your business. It’s important to choose wisely because your decision impacts not only how you will be taxed, but also how you can raise money from investors, manage operations, and grow the business. The protections available to LLCs have continued to be expanded and developed.
For the legal structure, you will most often be choosing between a limited liability company (LLC) and C Corporation (C-Corp). Both LLCs and C-Corps are legal structures that shield owners from personal responsibility related to the business’s debts and liabilities. The biggest differences exist in the formation, ownership, governance, and taxes that apply to LLCs versus C-Corps.
Here’s an explanation of each type of entity, and reasons why LLCs may be a better choice for startups.
What is an LLC?
A limited liability company has a structure with legal protections similar to a corporation, but is taxed as a sole-proprietorship (default for one owner), partnership (default for more than one owner), or S-corp (if elected). Excluding banks and insurance companies, any entity or individual can be an owner, or “member,” of an LLC. LLCs do not pay taxes on their profits directly. Profits and losses are generally passed through to members, who report them on their individual tax returns. Members are issued interests (similar to stocks) to prove their ownership, and officers or managing members are typically the ones who run the day-to-day business of the LLC.
What is a C-Corp?
A C-Corp is the most common type of company. The owners of C-Corps are shareholders or stockholders (of which there can be an unlimited number), and are issued stock as proof of their ownership. C-Corps are viewed as separate taxpayers by the IRS and pay a corporate tax rate. Profits are taxed at the corporate level, and shareholder dividends are taxed as well—this is sometimes referred to as “double taxation.” Typically, the shareholders elect a board of directors to determine how the company is run. C-Corps can be publicly or privately held.
** There are certain formalities necessary to maintain the legal protections for either structure.
Top 3 Benefits of an LLC for Startups
While many investors prefer C-Corp structures, every startup is different and there are many scenarios where the LLC structure is more beneficial. Here are three reasons why an LLC may be a better choice for your startup:
1) There’s No Waiting for Tax Savings
From a tax standpoint, LLCs can be beneficial because they are “pass through”—they don’t pay corporate-level federal tax. Founders, angels, and other investors can offset the tax loss from the LLC against their other personal income, which could be a huge tax advantage. If the company is losing money, the owner will see tax savings every year. In contrast, C-Corps generally carry losses forward with the intent of offsetting those losses with future profits. But, it’s very possible that the assumed tax benefit from structuring as a C-Corp is never realized.
2) You Have Flexible Ownership Arrangements and Compensation
LLC’s cannot issue stocks or shares like C-Corps, but they can grant ownership interests or “units” in the company, and set up preferential rights similar to preferred stock. In essence, these interests offer LLC members equity-based compensation that is analogous to the value of stocks.
Additionally, C-Corps have generally established guidelines in place for distributing different classes of stock, but LLCs do not. That lack of structure offers LLCs more creative flexibility with the ownership arrangements, which ultimately translates to more flexibility with how you structure the business itself.
This flexibility and customization does come with more paperwork and red tape, but is often worth the effort for early-stage startup companies that are looking to maximize their tax benefits and control over the business.
3) You Can Easily Switch From an LLC to a C-Corp
Some startups begin as an LLC and later convert to a C-Corp when the circumstances warrant such conversion. This switch typically happens when a startup company seeks additional funding from venture capitalists. The process to convert from an LLC to C-Corp is relatively easy and generally doesn’t involve unfavorable tax implications. This allows you to realize the tax savings and flexible equity agreements of an LLC for as long as possible, then transition to a C-Corp when that structure becomes more beneficial.
Still undecided on an LLC vs. C-Corp or need more help deciding which structure is best for your situation? We can explain more about each option and help you choose the business structure that is best for your owners and investors. Contact us today.