Choosing the form of your business entity is one of the first and most important steps toward running a successful business. Three of the most common entity types are C-Corporations, S-Corporations and Limited Liability Companies (LLCs). Each entity type has its own advantages and disadvantages, including with respect to taxation, attractiveness to investors and simplicity. For most companies intending to raise money from venture capital funds, a C-Corporation is the most common choice. However, S-Corporations and LLCs provide tax advantages that may make them more suitable for certain businesses. This article addresses the pros and cons of C-Corporations, S-Corporations and LLCs, and how you can determine which one may be right for your business.
The vast majority of our start-up clients elect to form their business as a C-Corporation due to its attractiveness to potential institutional investors, the well-established legal framework around corporate governance and the limited liability protection it provides to its owners. The largest drawback is potential double taxation. A C-Corporation is a separate taxpayer and pays its own taxes. As a result, any income earned by the C-Corporation is first taxed at the entity level and then again at the stockholder level when the net income is distributed to the stockholders.
Who Should and Should Not Choose a C-Corporation?
Any company planning to raise money from venture capital funds, tax-exempt investors or non-U.S. investors should strongly consider forming as a C-Corporation. However, if you do not anticipate raising funds from these types of investors and would prefer to avoid the double-taxation imposed on the C-Corporation, an S-Corporation or LLC may be better for you, as explained more fully below.
- Large Investors Prefer C-Corporations – Venture capital funds, tax-exempt investors and non-U.S. investors prefer investing in C-Corporations. These types of investors prefer this form of entity because the company’s income is taxed at the corporate level and does not flow up to them and subject them to tax and filing requirements. C-Corporations can also offer preferred stock, which allows its owners to be paid first in a liquidity event and can have other preferential rights, including with respect to dividends and voting rights.
- Limited Liability – The C-Corporation protects the assets of its stockholders by insulating them from the liabilities of the company in most cases.
- Sophisticated Statutory Structure – Assuming you incorporate in Delaware, which we recommend doing, the statutory rules governing C-Corporations are familiar to investors and provide clear guidance on corporate governance issues.
- Easy to Issue Equity Incentives to Employees, Consultants and Advisors – Because C-Corporations can issue multiple classes of stock, they are better equipped to issue attractively priced equity awards (i.e., stock options) to their employees, consultants and advisors. The value of the common stock underlying such equity awards is often less than the value of the preferred stock that would be sold to investors due to the liquidation preference of the preferred stock. In addition, unlike LLCs, C-Corporations can issue “incentive stock options” to its employees, which provide tax advantages not available with other equity awards.
- Availability of the Qualified Small Business Stock Exemption – Only C-Corporations are eligible to issue “qualified small business stock,” as defined by Section 1202 of the Internal Revenue Code, which generally allows stockholders holding qualified small business stock for more than five (5) years to exclude 100% of the gain on such stock upon sale, subject to a cap at the greater of $10 million or ten (10) times the basis of the stockholder’s initial investment.
- Double Taxation – Double taxation is the primary disadvantage of the C-Corporation. Double taxation means that the business is subject to two layers of income taxes: (i) first, the business is taxed at the entity level, when taxable income is earned and (ii) second, the stockholders are taxed when they receive distributions from the corporation, as dividends or otherwise.
- Less Flexible Structure and Corporate Governance Requirements – Though the extensive statutory provisions governing C-Corporations help provide clarity to investors, they also result in less flexible governing documents that must follow established corporate laws and procedures that can be burdensome for start-ups without near-term financing options.
Pass-through taxation is the S-Corporation’s biggest appeal. In other words, the S-Corporation is taxed in a manner similar to a partnership where the income and losses pass through to the stockholders. The stockholders, not the S-Corporation, pay the tax on this income. The stockholders are not taxed again when this income is distributed to the stockholders. However, the S-Corporation is subject to strict requirements it must follow to qualify as and continue to be an S-Corporation. If any of these requirements are not met, the S-Corporation automatically reverts to a C-Corporation. One of these requirements is only U.S. individuals, certain trusts and certain tax-exempt organizations can own the stock, which substantially limits the company’s eligible investors. Another requirement is that the S-Corporation can only have one class of stock.
Who Should and Should Not Choose an S-Corporation?
If you plan to raise venture capital in the near-future, an S-Corporation is not a good choice because it cannot issue preferred stock and may not receive investments from entities. The S-Corporation may be a good choice for a family or closely-held business that relies solely on individual investors and does not expect to issue substantial equity incentives to its employees and consultants. Also, you can start as an S-Corporation and become a C-Corporation down the road if you decide to seek venture capital investors in the future. However, if pass-through taxation is the primary consideration, the LLC may be preferable to the S-Corporation, as further explained below.
- Pass-Through Taxation – The S-Corporation is taxed on a flow-through basis similar to a partnership, which means that all income is allocated to and the tax on such income paid by its stockholders. The S-Corporation is not subject to the entity-level income tax that applies to C-Corporations.
- Conversion to C-Corporation – Forming your business as an S-Corporation and later converting it to a C-Corporation could be a good choice if you expect your initial funding to come from individuals, and venture funding not to arrive for at least a couple of years. This approach would allow your company to enjoy the benefits of pass-through taxation until larger investors decide to fund your company. However, any stock your company issues while an S-Corporation would not be eligible for the Qualified Small Business Stock Exemption.
- Limited Liability to Its Owners – Similar to the C-Corporation, stockholders are generally protected from the S-Corporation’s liabilities.
- Sophisticated Statutory Structure – Similar to the C-Corporation, the statutory rules governing S-Corporations are familiar to investors and provide clear guidance on corporate governance issues.
- Only One Class of Stock May Be Issued – Unlike the C-Corporation, the S-Corporation may only issue one class of stock, typically common stock. The unavailability of preferred stock, which is typically required by institutional investors (including venture capital funds) and sophisticated angel investors, will usually limit the S-Corporation’s funding sources to friends, family and less sophisticated individual angel investors. In addition, the availability of only one class of stock means the S-Corporation is not able to offer favorably priced equity awards to its employees, consultants and advisors.
- 100-Stockholder Limit – An S-Corporation may not have more than 100 stockholders.
- Only Individuals Can Be Stockholders – With certain limited exceptions, only individuals can be stockholders of an S-Corporation. Certain trusts and exempt organizations can also be stockholders, but no partnerships or corporations are allowed.
- No Foreign Stockholders Allowed – Only U.S. citizens or residents can be stockholders of an S-Corporation.
- Qualified Small Business Stock Exemption Is Not Available – Unlike the C-Corporation, the S-Corporation is not eligible to issue qualified small business stock to its stockholders, which may result in the lack of favorable tax treatment to long-term stockholders in future years.
- Less Flexible Structure and Corporate Governance Requirements – S-Corporations are governed under similar corporate governance laws as C-Corporations, which results in less flexible governing documents.
Limited Liability Company (LLC)
A Limited Liability Company, commonly referred to as an “LLC,” enjoys pass-through taxation (similar to the S-Corporation) and provides more flexibility in the drafting of its governing documents. However, the LLC is also subject to several drawbacks, including unattractiveness to some institutional investors, difficulty issuing equity broadly, potential issues relating to convertible debt financings and the inability to conduct an initial public offering.
Who Should and Should Not Choose an LLC?
Similar to the S-Corporation, the LLC is not a good choice for companies intending to raise money from venture capital funds or other institutional investors, but may be a good choice for companies planning to raise funds through its founders, other individuals and corporate investors. In addition, if pass-through taxation is the primary consideration, the LLC may be a better choice than an S-Corporation because the LLC is not subject to the investor limitations applicable to an S-Corporation discussed above.
- Pass-Through Taxation – Similar to the S-Corporation, the LLC is taxed as a partnership and therefore enjoys pass-through taxation. The LLC is not subject to an entity-level income tax, and all income taxes are allocated to and paid directly by its members.
- Flexible Structure – The LLC’s primary advantage over an S-Corporation is the flexibility provided by the LLC’s primary governing document, referred to as either a limited liability company agreement or an operating agreement. While a corporation’s governing documents are somewhat rigid in structure due to statutory corporate law, the LLC’s operating agreement can be customized to a far greater degree, allowing for features such as profits interests, multiple share classes and unique liquidation and distribution structures.
- No Eligibility Requirements – The LLC is not subject to the same investor eligibility requirements applicable to an S-Corporation. There is no limit on the number of members of an LLC, and there are no restrictions on non-U.S. members or corporate members. There may be reasons that non-U.S. investors may not want to invest through an LLC but that discussion is beyond the scope of this article.
- Limited Liability to Its Owners – Similar to corporations, the LLC’s members are generally protected from the LLC’s liabilities.
- Conversion to Corporation – Depending on the jurisdiction of initial incorporation and certain other factors, an LLC can often be easily converted to a corporation.
- Not Suitable for Venture Capital Financing – Although the LLC may issue multiple share classes, it is not a suitable entity structure for raising venture capital funds due to certain tax restrictions applicable to the tax-exempt and non-U.S. investors of such funds.
- Difficult to Issue Equity Awards – Unlike the corporation, where equity awards can be easily granted to service providers, it is much more complex to issue equity awards from an LLC. More commonly, LLCs will issue “profits interests,” which entitle their holders to a certain percentage of the LLC’s profits, and require different tax reporting and payment obligations that may be unfamiliar to and burdensome on many employees.
- Complexity – Though the flexible structure of the LLC can be helpful for tailoring a company’s mode of operation, such flexibility can also mean that the LLC’s operating agreement contains more complex, less standardized terms than a corporation’s governing documents. In the case of LLCs with multiple members, careful attention should be paid to drafting “deadlock provisions,” or terms that provide for the resolution of decision points when the members are deadlocked.
- Inability to Conduct a Public Offering – Unlike corporations, an LLC is not eligible to conduct an initial public offering. Any LLC desiring to conduct a public offering would first need to convert to a corporation.
- Potential Issues Related to Convertible Debt Financing – Corporations commonly issue convertible promissory notes as a form of financing. However, issuing such notes is substantially more complex in an LLC, and their terms will need to be more heavily negotiated among the investors and the company. The use of debt can also cause unexpected tax issues for the members when such debt is paid off or converted to equity or the LLC converts to a corporation.
- Qualified Small Business Stock Exemption Is Not Available – Like the S-Corporation, the LLC is not eligible to issue qualified small business stock.
So Which Entity Type Should You Choose?
If your company anticipates seeking financing from venture capital funds or other institutional investors in the near future, we strongly recommend forming your company as a C-Corporation. Venture capital funds and other institutional investors generally expect to receive preferred stock in exchange for their investment in your company, which may only be issued by a C-Corporation.
If you do not plan on seeking venture capital or other institutional financing, then an S-Corporation or an LLC may be a better choice as they each enjoy single-level taxation. In this case, we generally recommend forming an LLC because you will have access to a larger investor base and you are able to issue multiple share classes having different rights and preferences, similar to a C-Corporation. However, if you plan to run a family or closely-held business having only individual U.S. investors, and you don’t care about issuing different classes of equity, then an S-Corporation may be a better choice than an LLC because the governing documents are less complex than an LLC’s, equity awards are easier to grant and convertible note financings are less complicated.
This article provides general guidelines and includes important factors for consideration in your entity selection. Because of the number of factors involved, there is not always one “right” answer, and these general guidelines may not apply to your situation. For example, initially forming your company as an LLC and later converting to a C-Corporation may make the most sense for you if you plan to initially self-fund your company and then seek venture financing several years after initial formation. This approach would allow the initial start-up losses to be allocated to your company’s founders and early-round investors, but would also allow you to seek venture financing when the time is right for you.
Given all of the nuances involved with entity type selection, we recommend you seek the advice of legal counsel when deciding on the best entity type for your company.