ongratulations! After months of dreaming about turning your great idea into a real business, you have finally decided to take the plunge and form a company. After doing some initial research, you have decided to form your company as either a C-Corporation (“C-Corp”) or Limited Liability Company (“LLC”) since both entity structures offer personal liability protection against your company’s debts (meaning creditors of your company are not be able to come after your personal assets for repayment). However, how do you know which of these two entity structures to choose?
The answer to this question depends on a variety of factors, such as: How many people will initially be involved in the operation of your business? Will everyone be equally involved in management and have the same voting rights? How quickly do you anticipate scaling your business? Will you need outside funding, and if so, how much and how many outside investors will you want to bring on board? Do you plan on granting your employees/contractors equity-based incentives from the outset or down the line once your business grows to a certain stage? What kind of tax structure do you want?
Although you can always change your company’s entity structure down the line, doing so can be costly and may involve unnecessary administrative time and resources. In addition, choosing an entity structure that doesn’t align with your company’s needs, goals, or exit strategy can restrict how you operate your business and potentially inhibit or delay growth. Therefore, in order to help you make your decision, below is an explanation of some of major distinctions between these two entity types and some of the pros and cons of choosing each entity structure:
Taxation: One of the biggest differences between a standard C-Corp and a standard LLC is the manner in which they are taxed. A standard LLC is set up as a “pass-through” entity for tax purposes, which means that the LLC itself does not pay any income tax, and all profits, losses and distributions are attributable directly to the holders of the LLC’s membership interests. Thus, income to an LLC is taxed only once, as income to the members. Conversely, a standard C-Corp is subject to a “double taxation” structure, which means that profits are first taxed at the company level and then again at the shareholder level whenever distributions (i.e., dividends) are made to its shareholders. Therefore, one major advantage of the LLC entity structure is the favorable “pass through” tax treatment that this type of entity structure affords to its members. While a C-Corp can in certain specific circumstances receive “pass through” tax treatment by making what is called an “S-Corp” election, doing so requires several significant threshold requirements that limit or eliminate this option in most cases and generally inhibit outside investment (e.g., the number of shareholders must be capped at 100, prohibition against more than one class of shares, and no partnerships or other corporations can be shareholders).
Although the “pass through” tax treatment is very beneficial to founding members and early stage equity holders, it should be noted that this type of tax treatment generally results in adverse tax consequences to venture capitalists and certain other larger-scale investors based on how they are structured. Therefore, if you are planning on scaling your business quickly and anticipate significant outside investment at an early stage, the C-Corp structure will likely make the most sense. However, if you are not planning on bringing in major outside investments, or you do not anticipate engaging in a major investment round at an early stage, you will likely benefit more from the “pass through” tax structure that the LLC structure affords.
Ownership: In a C-Corp, the owners of the company are called “shareholders”; in an LLC, they are called “members.” Neither entity structure limits the number of owners the company can have (unless an S-Corp election has been made), and both structures offer a fair amount of flexibility with respect to establishing various ownership classes that are entitled to different ownership benefits. For example, a C-Corp can offer “preferred” shares with special dividend/liquidation preferences and certain other voting protections to a priority set of investors, and “common” shares to other smaller or early-stage investors with secondary dividend/liquidation preferences and/or voting rights to those of preferred shareholders. An LLC can also have multiple classes of members, each with different voting rights and profit distribution/liquidation preferences. However, the different membership classes in an LLC must be set out in the company’s operating agreement (the document governing the way in which an LLC operates) and so there is less flexibility in changing this structure down the line, particularly as the number of members grows, since all members would need to approve and sign an amendment to this document in order for it to become effective. Unlike an LLC, a C-Corp’s bylaws (the document governing how a C-Corp operates) are drafted more broadly and typically don’t require an amendment in order to establish new classes of stock (a majority vote of the board and/or shareholders generally suffice). Therefore, the greater ease in establishing and defining new classes of shareholders is a benefit of the C-Corp structure and makes it easier to bring in outside investors looking for preferential treatment on returns.
Despite the above, one benefit of the LLC structure is that, unlike with a C-Corp in which dividends must be paid in accordance with a shareholder’s ownership percentage, distributions of LLC profits can be made to members regardless of the actual capital contributions made by such members. Therefore even if one member may have only contributed 25% of the company’s total capital contributions, the LLC can still provide that this member receives 50% of all profit distributions if the member provides services or other non-cash benefits to the company. This feature can be particularly beneficial if there are a small number of members with varying degrees of management responsibility, since the LLC can allocate distributions in accordance with actual company involvement, even if each initial member puts the same amount of capital into the company to get it started.
However, one major drawback to the LLC structure is that nearly all larger and more sophisticated investors and venture capitalists prefer the C-Corp structure. This is partially because the shares of stock issued to owners of a C-Corp are more easily tradeable and transferrable than membership interests held by owners of an LLC, which makes it easier to accomplish an exit (such as an IPO), and partially because the LLC operating structure makes it more complicated to delineate or change preferential distribution rights. Therefore, if you anticipate scaling your business quickly and/or requiring substantial outside investments at a rather early stage, the C-Corp structure is likely your best option. On the other hand, if you think you can sufficiently fund your company through its early stages and only anticipate having a small number of partners, the C-Corp structure may not be necessary (although you may ultimately need to convert your company into a C-Corp later in the future once you reach a certain growth point).
Management: An LLC has a much more flexible and less formal management structure than a C-Corp. It can be structured such that a separate and distinct board of managers/directors (who may or may not also be members of the company) is granted the power to operate the company and handle its day-to-day business affairs (or appoint officers to do so), or such that all of the members are directly in charge of managing and operating the company’s business. Typically, when a separate board of managers/directors is established, approval of the members is only required for major company decisions (such as a sale or dissolution of the company) and the managers do not otherwise need to consult with the other members to approve an action on behalf of the company. When the members elect to manage the company directly, approval of company actions is typically just done by majority vote of all members (although certain major decisions may also require a supermajority vote or unanimous consent). Conversely, a C-Corp is required to distinguish between its owners and its managers and must appoint a separate board of directors (who may or may not also be shareholders) responsible for overseeing the management responsibilities of the company. Except for certain major corporate decisions requiring shareholder approval (such as a sale of the company), the board of a C-Corp is responsible for overseeing the day-to-day operations, and approving the actions, of the company, and has the right to appoint or remove the company’s officers who typically handle day-to-day management duties.
Additionally, unlike with an LLC, which typically has much looser formalities and record keeping requirements, all meetings of the board of directors and shareholders in a C-Corp are required to be recorded, all actions not made at a meeting must be formalized by a written consent, and everything must be filed in the minute books of the company. A C-Corp is also generally required to hold at least an annual meeting of shareholders and regularly scheduled meetings of its directors and in nearly all states there are financial/accounting requirements and other annual filings not required of an LLC.
Equity-Based Incentives: Unlike in an LLC, a C-Corp allows for the easy creation of a separate pool of shares (stock options, restricted shares, etc.) that can be set aside and reserved for potential partners, investors or employees who may join or work for the company in the future. This enables new/additional partners, investors, or employees to be compensated with equity in the company without further diluting or otherwise impacting the existing equity interests of the current shareholders. Conversely, with an LLC, every time new equity interests are granted, the members will all be required to adjust their existing equity stake accordingly, which can be complicated to do when the value-add/capital contributions of each member are different and/or the members cannot agree on how to adjust/dilute their interests for the new equity issuance. Therefore, a substantial benefit of the C-Corp structure is that it provides a powerful tool for hiring and retaining high-quality individuals who have an aligned interest in staying with the company long-term and ensuring its future growth and success. This is particularly useful in situations where cash is limited as it allows the company to compensate its employees and/or executives in addition to, or in some cases even without, a fixed salary payment.
Conclusion: Both the LLC and C-Corp entity structures have their benefits and drawbacks, and so you will ultimately need to determine which characteristics are most important for your business when making your decision. Generally speaking however, if you anticipate your company to be managed and/or owned by a small group of individuals who will each be active in growing the business, and you want to scale the business slowly, or believe you can scale the business without much need for outside capital investment, the LLC structure is likely a better option. However, if you anticipate having a larger number of owners, each with varying degrees of participation/contribution, you plan on hiring lots of employees to perform the day-to-day business functions, and/or you want to grow fast or anticipate multiple rounds of outside investment, then the C-Corp structure is likely the way to go.
Filed in: Legal Blog
February 21, 2017