Once you have started your own business, one of the first decisions you must make is choosing the form in which you want to conduct your business – whether as a sole proprietorship (or partnership, in case of more than one founder) or by organizing your business in an entity form. Your choice will lay the foundations for your business and guide tax efficiencies, liability exposure, administrative ease, attractiveness to investors, and therefore, your ability to scale. Also, choosing a form that best fits your needs helps avert disputes and prevent misunderstanding among the stakeholders by defining their ownership, roles, and duties in the business.
Whether your business should be organized as a corporation, partnership, limited liability company (“LLC”) or a sole proprietorship, depends on various factors including your goals for the business, whether you intend to raise outside capital, whether your business will be a lifestyle business, (on lifestyle businesses review our blog The basics of a Lifestyle Business versus a Startup), your desired tax treatment for the business, whether you intend to offer equity to employees and service providers, and so forth. However, in this blog we limit our discussion to adding our two cents to the ever-going debate of whether a new business should organize as a C-corporation (“C-Corp”) or an LLC. Our conclusion, to no ones’ surprise we hope, is there is no one-size-fits-all answer.
Arguably, one of the biggest drawbacks of a C-Corp is the potential for double taxation. A C-Corp is a separate taxpayer independent of its stockholders. The income earned by the C-Corp is first taxed at the entity level and then again in the hands of its stockholders when the net income is distributed to them as dividends. For the same reason, distributing cash to the owners on an ongoing basis is difficult to accomplish with a C-Corp (though by no means impossible). Also, to avail the protection from personal liability that C-Corp affords its owners (and to avoid the piercing of the so called “corporate veil”), it is important that a corporation complies with all corporate formalities stringently. LLCs (which also shields its owners from personal liability) offer much more flexibility in matters of corporate governance. Also, statutorily mandated fiduciary duties of the board of directors of a corporation cannot be eliminated by the corporation’s owners via a private agreement, whereas the members of an LLC have much flexibility to reduce (or altogether eliminate in some states) a manger’s (or managing member’s) fiduciary duties to the LLC and its non-managing members through the LLC’s operating agreement.
LLC’s are also a more attractive option than C-Corps for small businesses (or lifestyle businesses) that do not want to scale up rapidly and whose owners desire to distribute the earnings of the business based on a flexible structure or with regularity. This is because LLCs offer greater operational and managerial flexibility compared to C-Corps; its members can alter the default state laws through an operating agreement and essentially agree on anything including allocation of income and losses, scope of duties of its manager, distribution of assets upon liquidation, etc. Also, LLCs by default have only one layer of tax and are “flow-through” entities for taxes. The losses, deductions, credits, and other tax benefit items pass through to an LLC’s members and may offset other income on their individual tax returns (subject to certain limitations). LLCs are easier to form than C-Corps because they involve fewer organizational formalities.
However, despite the potential for double taxation, greater number of formalities and rigidity, a C-Corp may still be the winning choice for many, especially startups that intend to follow the traditional route of raising capital from venture capital funds, issue equity incentive awards to employees, create a successful exit strategy for the founders or to grow into a publicly held corporation. Founders regularly choose the C-Corp structure because of these advantages:
ease of raising capital because C-Corp continue to be the entity of choice for venture capital funds as opposed to LLCs or other flow-through entities due to certain tax implications.
familiar and well-developed legal frameworks and governance laws;
ability to transfer corporate stock more easily than LLC interests;
ease of offering ownership interests to employees and service providers in the form of stock options; and
shareholders not being subject to self-employment taxes on the corporation’s income whereas LLC members are generally subject to self-employment tax on their distribution of the ordinary trade and business income.
Therefore, as you may have concluded, when deliberating between a C-Corp and an LLC, all these factors must be analyzed considering your circumstances and business goals. The only piece of advice if we may leave you with, is to remember the old saying, “penny wise and pound foolish” and not skip the important step of consulting an attorney or an accountant to carefully consider which form of entity will serve your needs best.
 Of course, a corporation may also opt to have a flow through tax structure by making the so-called S-Corp election. However, for the purposes of this blog, we assume a scenario where the only two choices being considered are between a C-Corp and an LLC. On the requirements for an S corporation, see https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations