Entity type: corporation or LLC?
Founders often come to us before they have formed a legal entity, seeking advice about the type of entity to form –usually it is between the two most common entity types, limited liability companies (LLCs) and corporations. The type of entity will not determine whether the business succeeds or fails. Still, entity selection merits consideration. goodcounsel is adept at guiding founders through this decision.
Here are some of the more important issues to consider when deciding between an LLC and corporation.
LLCs are more flexible than corporations because an LLC is fundamentally a creation of contract. This contract is called the “LLC agreement” or “operating agreement.” It contains the rules that govern the company and is signed by the members of the LLC. State statutes still apply but generally, these simply provide default rules that govern in the absence of an operating agreement. Even fiduciary duties of the company’s managers may be eliminated almost entirely by the operating agreement – the rationale being that LLC managers should have more freedom to contract around the company’s business needs.
Corporations are governed by certificates/articles of incorporation or “charters,” which must comply with more statutory requirements than LLCs. For example, the fiduciary duties that directors and officers of a corporation owe to shareholders cannot be eliminated.
Most investors are comfortable with investing in an LLC. However, some professional and foreign investors may prefer investing in a corporation, usually for technical tax reasons such as UBTI and withholding. If you have already formed an LLC, remember that you can always convert the entity to a corporation if the company’s investment goals change.
Corporate stock, unlike LLC interests, may qualify as Qualified Small Business Stock (QSBS), a significant tax benefit that early-stage investors seek, though one that is subject to several conditions. (Note, however, that the new, sweeping tax bill currently under consideration by Congress would, if passed, substantially limit the QSBS capital gain exclusion for certain taxpayers.)
LLC taxation is efficient but can become very complicated. By default, an LLC is taxed as a “passthrough” entity, meaning that there is no tax at the entity level; the profits and losses pass through to the owners and are reported on their individual tax returns. This allows founders who contribute capital to deduct early losses. (In some cases, investors may also be able to deduct losses immediately.) An LLC must report each owner’s share of the company’s profits and losses on Form K-1s for each owner. This can be a time-consuming task. We suggest that multi-member LLCs (especially those anticipating growth and investment) consult an accountant with specific expertise in partnership taxation.
While LLCs result in one level of taxation, corporate profits may be taxed twice. First, the corporation pays taxes on its profits annually; then, when the corporation distributes profits in the form of dividends, the stockholder pays income taxes. The lower tax rates on corporations narrows the gap with LLCs and the magnitude of the difference also depends on the mix of profits or losses the business will generate early on, but generally, we expect the tax burden on a corporation to be somewhat higher than that on an LLC.
LLCs can issue a particular kind of incentive equity called “profits interests,” which enjoy favorable tax treatment for the recipients compared to corporate options. See this post about incentive equity and this post about profits interests.
Corporate charters are public documents that anyone may obtain and view. LLC agreements, by contrast, do not need to be filed.
goodcounsel makes certain that its clients are properly advised when choosing an entity type. Contact us if you need help!
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