When working with start-up companies we are frequently asked whether it is preferable to form a new entity as a corporation or as a limited liability company. While there is no one-size-fits-all answer to this question, below are some high-level pros and cons of each entity. The attached chart will also help you organize some of the issues related to this initial and important decision.
- Operations – LLCs are subject to fewer formalities than corporations. For example, while corporations are required to hold regular meetings of the board of directors and to keep written meeting minutes, LLCs are under no such obligations.
- Ownership – Unlike S-Corporations (“S-Corps”), LLCs face no restrictions regarding who can be an owner and have no cap on the maximum number of owners.
- Taxation – LLCs have flexibility to choose the tax identity that most benefits their members: an LLC, in other words, may elect to be taxed like a partnership, a C-Corporation (“C-Corp”), or an S-Corp. Active members of an LLC can also realize tax savings by deducting operating losses from the business (which are common for start-ups) against their regular income.
- Operations – Because the LLC form is relatively new, some bankers and vendors may be more reluctant to extend credit to an LLC than to a corporation.
- Ownership – The ownership of an LLC is more centralized than that of a corporation. Any member of the LLC may act as a manager and bind the business through a contract.
- Taxation – The default tax status for an LLC is as a “pass-through” entity, which means that income from the business is taxed to the owners at their respective tax rates. Relative to corporate taxation, pass-through taxation may disadvantage businesses that do not plan to distribute all profits to their owners. See “income splitting” below.
- Operations – Corporations may be perceived as more professional or legitimate than LLCs, which can be advantageous when seeking investors or creditors.
- Ownership – Unlike an LLC, a corporation can go public. For this reason, venture capital firms prefer to work with corporations. Ownership in a corporation is easily transferrable through the sale of stock.
- Taxation – Corporations of a certain size can realize tax benefits by utilizing a strategy known as “income splitting.” Because a corporation is a separate taxable entity, the corporation’s income may be split so that part of it is taxable to the corporation and part of it is taxable to the corporation’s owner(s), resulting in a lower tax rate for each. LLCs may not take advantage of this strategy.
- Operations – Corporations are subject to more formalities than are LLCs. They must hold and properly document regular meetings of the board of directors, adopt and regularly update bylaws, and formally define the roles and responsibilities of corporate officers and directors.
- Taxation – The major disadvantage to forming a corporation is the double-taxation of income. The income a corporation generates is taxed once, and when the corporation pays dividends to its owner(s) that income is taxed again.
S-Corp vs. C-Corp:
- The primary distinction between S-Corps and C-Corps is their tax treatment. Like an LLC, an S-Corp is a “pass-through” entity, meaning income from the business is taxed to the business owners at their individual tax rates. Like LLCs, S-Corps do not face double-taxation; C-Corps, however, do face double-taxation.
- S-Corps face ownership restrictions that limit the number of shareholders. These restrictions do not apply to C-Corps.
- Both S-Corps and C-Corps are more complicated than LLCs from a tax and legal standpoint. Consequently, both S-Corps and C-Corps will likely carry greater accounting and legal costs when compared to LLCs.