So let’s say you’ve come up with a great business idea. You have already put together a business plan. You know that you need a legal entity for your business. Your next step—and probably the concern I hear most frequently—is to decide what sort of entity your business should be.
There are a lot of legal entities out there: partnerships (general, limited liability, limited liability limited), trusts of all sorts, non-profits, corporations, limited liability companies, and more. For most businesses, only two of these are good options: corporations and limited liability companies (LLCs). Corporations can be further divided into C-corporations and S-corporations.
Corporations and LLCs are each good business entities, but there are important differences between them. While an LLC is generally the best default entity for most businesses, not every business should be an LLC. Before choosing an entity, you should think about your long-term strategic goals. Choosing the wrong entity won’t kill your business, but it can be a costly mistake.
For a quick rule of thumb, if you are forming a startup with plans for rapid growth, external equity funding—by which I mean angel investors and venture capital—and you hope to eventually by acquired or file for a public offering, you should be a corporation. Specifically, you should be a C-corporation. Pretty much everyone else should be an LLC, or in some cases an S-corporation.
(I should point out now, as an aside, that the distinction between these entities can become somewhat blurred. Limited liability companies are creations of state law and are not recognized by the federal government. When the federal government—particularly the IRS—sees an LLC, it sees either a partnership, which is the default and what most LLCs prefer, or it sees a corporation. The difference will depend on the specific tax election that the company has made. If the LLC elects to be taxed as a corporation, it can further elect to be taxed as an S-corporation. So you can have an LLC with the tax characteristics of a C-corp or S-corp. When I say LLC in this post, I mean the default: an LLC that is taxed as a partnership. Just keep in mind that an LLC can also elect to be taxed as a C-corporation or an S-corporation, and in some cases that will make sense.)
The simple reason that most startups should be setup as a corporation is that it’s what investors and capital markets demand. If your ultimate goal is to bring on investors as efficiently as possible, and then to sell your company or go public, you should focus from the outset on making your company as attractive as possible to investors and markets.
There are two mains reasons why investors and capital markets prefer corporations. First, many venture-capital funds are prohibited by their organizing documents from investing in LLCs. (This is to avoid Unrelated Business Taxable Income passing through to the fund’s investors.) Second, corporations—particularly Delaware corporations—have a long history backed by heaps of legal precedent. Ownership interests in a corporation, designated by shares, are well understood, fairly standardized, and readily listable on public exchanges. LLC membership interests on the other hand are often highly customized and therefore not readily tradeable.
The downside to the corporate form—by which I specifically mean C-corps—is double taxation. Double taxation means that the corporation pays tax on any income that it earns, and then if the corporation distributes any of what’s left to its shareholders (through a dividend), the shareholders must pay tax again. Depending on the applicable corporate and individual rates in place at the time, this double tax can take a significant chunk out of your bottom line.
LLCs and S-corporations avoid the problem of double taxation because they are “flow-through” or “pass-through” entities for tax purposes. Income flows through these entities and is taxed directly to the owners. That’s because, although LLCs and S-corps are both considered legal entities at the state-law level, in the IRS’ eyes, at the federal level, they are considered non-entities: sole proprietorships or partnerships. Sole proprietorship and partnerships only pay tax at the individual level. So income earned by an LLC or S-corp is reported on the owner’s personal return and taxed at the owner’s applicable income-tax rate, as if the owner was a sole proprietor or general partner. (The precise flow-through mechanism varies between the two types of entities.) This tax advantage is why most small businesses that don’t plan on raising venture capital or filing for a public offering should establish themselves as an LLC or S-corp.
Between the LLC and S-corp, most businesses are better off as an LLC. An LLC is flexible, from a corporate governance standpoint—which is part of the reason it’s hard to trade LLC interests; an LLC carries relaxed formality requirements—so you don’t have to worry about annual meetings and the like; and an LLC implicates only one level of tax. For most closely held businesses, an LLC is perfect.
Money is always tight at a startup, and often startup founders tell me they are concerned by the second level of tax that they’ll have to pay if they setup as a C-corp. So they plan to set up shop as an LLC or as an S-corp, and either try to raise money using that entity, or convert to a C-corp when investors show up and demand it.
On its face this strategy makes sense because it avoids the double tax, but it’s typically a mistake for several reasons, two of which really stand out. First, if the company really is a startup, there won’t be any big distributions to tax. The founders might get a small, tax-deductible salary. And maybe the founders will take a small distribution at Christmas time (but, see next paragraph). But the vast majority of your startup’s income will be (or should be) plowed back into your company. The company’s income will be taxed, but there will be no distribution to double tax.
(Why no distributions, you might ask. Because you’re trying to grow a company, and growth requires cash. Plus, where can you find a better return on that money than in your own startup? If you aren’t investing everything you can in your own startup—and if you aren’t confident of your own ability to “out return” the market—why would you expect outside investors to put their own money on the line?)
The second reason it’s a mistake to start with an LLC or S-corp and then convert is that your tax savings can easily be wiped out by the potentially huge costs of converting an established flow-through entity to a corporation. You will be converting the entity from a partnership structure to a corporate structure. The two are quite different from tax and accounting standpoints. The conversion will have the effect of either an asset or a security transfer, depending on how it’s structured. The whole process will be a mess. Equity will need to be reissued, vesting schedules reset. Many of your contracts may need revision. And you could even get hit with a tax bill for your troubles. Conversions do happen, but they’re expensive. Avoid the trouble and expense of converting from one entity to another by planning ahead.
