When starting your company, is it better to form a corporation or an LLC? There are a number of factors to consider in making this decision, including your business strategy and the tax implications associated with it. In this article, we’ll go over the most common factors that I’ve seen in my legal practice.
Management Structure
Corporations have a fairly standard management structure. There are the shareholders, the directors, and the officers. Among the officers are a president, secretary, treasurer, and the C-suite. The shareholders elect and determine the responsibilities and compensation of the directors, and the directors elect and determine the responsibilities and compensation of the officers. This management structure is streamlined, predictable, and hierarchical.
LLCs, on the other hand, have an extremely fluid management structure. They can be managed directly by the members on any majority voting basis, or they can be managed by appointed managers. The hierarchy of management may be structured exactly like a corporation, with managers elected to roles that resemble those of the shareholders, directors, and officers of a corporation. Alternatively, LLCs may be managed by just one individual, and this individual may be granted absolute authority over the members without the possibility of removal.
In deciding between a corporation or an LLC, think about the management structure that would best align with your business strategy.
Tax Implications
Corporations are subject to double taxation, meaning that after the entity pays tax, any profit distributions are subject to an additional round of taxation. On the other hand, LLCs can elect to be taxed as flowthrough entities, meaning that the entity isn’t subject to taxation, and that any profit distributions are counted as personal income of the members.
While this isn’t a big deal for early-stage businesses that have yet to turn a profit, the differences could pile up as you start generating revenue. Factors to consider include:
- If the personal income tax rate in your jurisdiction exceeds the corporate tax rate by far, then you may want to consider keeping most of your profits in the business, in which case there would be no difference between a corporation and an LLC. This strategy works for solo entrepreneurs or family businesses, but stops working as businesses expand to bring on new people, as it would be impractical to not distribute profits to the members.
- From an accounting standpoint, converting between a corporation and an LLC can be costly because taxes usually need to be paid upon an entity change. More specifically, since taxes for corporations and LLCs are calculated differently, there may be gaps to the IRS that need to be filled upon a conversion. You should plan out your tax strategy early on so that you can file for the right type of entity early on and avoid entity-change taxes later down the road.
Investor Preference
Investors usually prefer corporations. Why? Because corporations have a fixed number of authorized shares and investors know exactly what they’re getting in terms of both the number of shares and the percentage of equity in the company. This makes it easier for them to attach certain rights to their investment, such as anti-dilution rights, drag along rights, and pro rata rights.
On the other hand, LLC interests are weighed proportionally between all the investors. There is no fixed number of interests, and investors can only receive a percentage. This makes it easy for them to be diluted in subsequent fundraising rounds or suffer otherwise from a lack of certainty as to exactly how much equity they own.
Consider if you’ll be raising from institutional investors down the road, or if you’ll mainly be bootstrapping throughout.
Stock Options
Because they have a fixed number of shares, corporations can easily issue stock options or allocate a stock option pool. They just need to earmark some shares for this purpose. LLCs can’t do this as, again, equity is issued as a percentage. It’s simply impossible to allocate a certain percentage of interests when equity is weighed proportionally between members. When making the choice between a corporation or an LLC, think about whether you’ll want to issue equity to employees, advisors, or co-founders further down the road, or whether you’ll want to keep all ownership of the company with the original founders.
Simplifying Your Startup Structure
While decide on all of the aforementioned factors before your company is even created can feel like a monumental task, keep in mind that from a legal standpoint, it’s pretty easy to convert between a corporation and an LLC. As long as you do it before your company grows too big, you probably won’t have to worry about paying any additional taxes. This article is meant as a general guide if you’re feeling lost in the early stages of your entrepreneurship journey.
