Business Startup 101: Should you form Inc. or LLC ?
There are three primary kinds of entities most startup founders in the U.S. will consider:
There are a number of primary factors when trying to make the choice between these:
(a) will you be seeking outside investors – and if so, when?
(b) will the company be generating a profit anytime soon?
Lets compare and contrast the three types of entity.
An LLC is very easy to set up. It is also, contrary to popular belief, an entirely legitimate corporate entity. You define who the “members” are and how much each member owns as a percentage. I believe you get the same protection from personal liability as you would get from setting up a full C-corp. One of the great features about an LLC is that there is almost no regulatory BS to deal with. You are not subject to the same arduous rules /disclosures/expensive accounting that a C-corp has to adhere to.
Another big advantage is that the LLC is not taxed as an entity. The members are taxed, usually in ratio to their ownership percentages. Why is that an advantage?
A) When you are a startup, you will be losing money. Your prorated portion of that loss can be applied to your personal tax return (Schedule C). If you have no personal income, the IRS gives you a choice. You can roll your loss forward and use it to offset future income, or you can go back through the last three years of tax returns and apply the loss retroactively. That reduces your adjusted gross income, often leading to a refund. It can be quite beneficial in some circumstances. When you want your LLC to be treated as a separate entity (Not included on your 1040) you must then file form 8832.
B) If you are a C-corp the company is a tax paying entity — it pays tax on all income. If the company pays you, you pay personal income tax. i.e. money coming in to the company is taxed twice by the time you get it.
Sounds good so far? LLC is a GREAT structure and is perfect for many situations. However, it does not really allow for shareholders, so if you have outside investors, an LLC is probably not going to fly.
2) The C-corp. This is your full blown corporation. A C-corp is a legal/tax entity in its own right, so you get maximum protection etc. The issue with a C-corp is that you have to have a board of directors, adhere very carefully to certain reporting requirements and generally keep your finances and operations in good order. A C-corp has shareholders, can issue stock to anyone and is a respected and expected structure for most investors. You’ll have the double taxation issue mentioned above, but if you want investors to put money in your company, you need to be a C-corp, unless you meet the requirements for an S-corp.
3) The S-corp. An S-corp is really a C-corp with special permission to behave differently. The “s” refers to a subsection of the U.S. Tax (IRS) code. You form a C-corp and then take an S-election if you qualify. You have all of the regulatory side of a C-corp, but the tax pass through advantages of an LLC. The caveat: there are significant restrictions on the type of investors. Your investors cannot be corporations (i.e. VC’s) or persons non-resident in the USA. There are some other restrictions too as to the number of shareholders etc. When you want to become a S-corp you must file form 2553 after C-corp formation.
To qualify for S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders
- including individuals, certain trust, and estates and
- may not include partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have one class of stock
- Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.
My personal practice has been to create an LLC (they are simple, avoid double taxation and still support multiple classes of stock if needed). If and when the time comes to “convert” the LLC to a C-corp, the process is not that difficult. Whatever costs you’d incur in the “conversion” process, I think are offset by the upside you get during the time that you can benefit from being an LLC. An LLC can be setup for a few hundred dollars and likely meets the needs of most early-stage entrepreneurs.