One of the most important decisions founders make is whether to form a LLC or a Corporation. This post can help you decide which is best for you.
When starting a new business you will usually create some form of business entity – the most popular options are Limited Liability Companies (LLCs) and Corporations. At the outset, you should keep in mind that you don’t want to create an “accidental partnership” because that can lead to all kinds of problems and also keep in mind that an S-Corp isn’t really a business entity, it’s just a tax classification.
Here are a few factors to consider when deciding which is best for you:
1. Formation Process & Annual Reports
It’s very easy to form both LLCs and Corporations today. In most states you can form the company online by filing a short form and paying a small fee (usually less than $200). By forming an LLC or Corporation, you are creating a legal business entity that is separate from its owners. Thus, the owners benefit from limited liability.
Depending on your state, you may or may not need to file ongoing reports with the Secretary of State. For example, Kansas requires both LLCs and Corporations to file annual reports, while Missouri only requires Corporations file annual reports.
2. Governing Documents
Every LLC should have an Operating Agreement that outlines the rights and responsibilities of the LLC’s owners (called Members) and identifies each member’s economic and voting rights. It will also contemplate issues like distributions of capital, transfer restrictions, and more.
Similarly, every Corporation should have Bylaws and most likely a Shareholder Agreement. The Bylaws will outline how the company should operate (such as how to elect directors, how to elect officers, how money is distributed, etc.) and the Shareholder Agreement will be an agreement between the shareholders placing restrictions on the transferability of their ownership interests among other things.
Both LLCs and Corporations are very flexible when it comes to creating and issuing different types of ownership interests. Each can have common ownership interests, preferred ownership interests, and also economic-only ownership interests. However, if you need to create option pools, then you should consider forming a Corporation because LLCs are limited in terms of creating option-style ownership interests.
LLCs are very flexible when it comes to management structure. They can be “member-managed” in which case all of the members have power to sign contracts for the company or “manager-managed” in which case only the designated managers can sign contracts for the company. You can also create management boards, officers, and more, provided you document the structure in your operating agreement.
Corporations are more formal. Most states will require you to have a Board of Directors and Officers. In many states, you must also list your directors and officers on public filings with the Secretary of State. The Shareholders elect the Board, the Board elects the Officers, and the Officers run the company day-to-day.
Perhaps the biggest difference between LLCs and Corporations are taxes. (We’ll ignore S-Corp taxation here, but you can read more about that in this series.)
LLCs are usually considered “pass-through” entities which means the LLC itself doesn’t pay any income taxes. Rather, each member will report their share of income/loss on their personal tax returns (regardless if profits are actually distributed or not). This is a big benefit of being an LLC (a lower tax liability), but also a negative to some people (especially professional investors who don’t want to receive stacks of K-1s each year from their portfolio companies.)
Corporations on the other hand are subject to “double-taxation” which means the Corporation will pay taxes on its income and then the shareholders will pay another layer of taxes on distributions they receive. As a result, the tax liabilities associated with corporations can be much higher than for LLCs.
What You Should Do
While many business formations are “standard” or “routine,” you should still consider speaking to a business attorney about your specific situation. There are a million factors at play and he or she can help you identify the biggest issues in your situation as well as plan for the future.
In many situations it is best to take advantage of the benefits and flexibility of an LLC in your early days and, if appropriate later, convert to a Corporation. However, that isn’t always the right answer.