I’m Starting a Company – should it be an LLC or a C-corp?
Most new start-ups are structured either as limited liability companies (“LLCs”) or C-corporations. Generally speaking, LLCs and C-corps both shield their owners from personal responsibility for the liabilities of the business, and both are able to enter into transactions and conduct business as independent legal persons. However, there are a few key differences between each structure.
C-corps:
C-corps are subject to strict legal requirements in respect of governance and decisionmaking – state law allocates certain decisions to the individual stockholders of a C-corp, and certain decisions to its Board of Directors, which each C-corp is required to form.
The members of the Board of Directors are subject to fiduciary duties, which means they need to take into account the interests of the company’s stockholders as a whole (and not just their own) when making their decisions.
This can make decisionmaking at C-corps more unwieldy and with additional formalities.
For tax purposes, C-corps are treated as independent taxpayers, which means they owe taxes on all net profits of the business. Shareholders then owe additional taxes on any distributions they receive from a C-corp, which means that each dollar earned by a C-corp will be “double taxed” by the time it makes its way to an underlying shareholder.
LLCs:
LLCs are typically subject to fewer legal requirements related to corporate governance – an LLCs operating agreement can provide for flexible decisionmaking mechanics, and can eliminate any and all fiduciary duties on behalf of the company’s managers.
As a default, LLCs are taxed as partnerships. This means that profits and losses of the business are not recognized by the LLC itself, but rather are “passed-through” to the LLC’s members, who include those amounts on their personal tax returns. For high-cash flow business, this helps eliminate the “double taxation” effect of with C-corps.
Which do I choose?
Founders often choose LLCs if they are starting a business that is likely to generate significant free cash flow that will then be distributed out to investors and owners. Pass-through LLC taxation ensures that these profits are able to make their way into investors’ pockets as tax efficiently as possible. Restaurants, retail businesses and services companies typically use an LLC structure.
On the other hand, C-corps will almost always be the preference for companies aiming to reinvest profits and scale toward an exit via an acquisition or IPO. Shareholders are often able to benefit from lower capital gains tax rates and favorable “qualified small business stock” rules in connection with the eventual sale of their stock.
A C-corp will also make sense where you are planning to raise institutional venture capital, as institutional investors will insist on investing into a company structure that won’t result in profits being passed through to underlying VC limited partners. Although it’s possible to convert an LLC into a C-corp prior to a formal VC financing round, given the current macro-environment it’s usually best to make the process of raising institutional capital as smooth as possible.
Finally, C-corps can make it easier to attract and incentivize top talent, as tax rules permit C-corps (but not LLCs) to offer equity incentives like stock options and restricted stock awards.
Disclaimer: All of the information included in this website is provided for informational purposes only and should not be construed as legal advice. Please contact us for more information.