When Do I Form a Corporation or an LLC?
Arguably, one of the most important decisions that will affect the ultimate success of a business, whatever its size is the decision of how to incorporate that business. There is a fairly wide range of choices to choose from, from sole proprietorships on up to regular C corporations.
A business entity that has seen a meteoric rise in usage in the past few decades is the Limited Liability Company (“LLC”), and for good reason – LLCs come with a host of advantageous characteristics that combine some of the best traits of several options available to business entities.
LLCs combine limited liability for members with the flexibility to choose how they’re taxed, such as flow-through taxation akin to partnerships (e.g., no taxation at the entity level, as there is with regular C corporations). With the rise in the popularity of LLCs, however, it’s helpful to know when there are advantages to choosing the venerable C corporation form over the upstart LLC. Also, as an LLC, you can elect Subchapter S (S-Corp) taxation status.
Courting Investors
While LLCs work well with a limited number of investors the needs of a business may change as it sees the number of its investors increase. An entity may become difficult to manage with additional members/investors. Also, LLCs face difficulty in courting investment from venture capitalists due to the structure of the entity and the limitations on such things as ownership availability, liquidity and stock issuance. When this occurs, it may be in the businesses best interest to look to the tried and true formula of a C corporation as a better fit for such forms of investment. Nevertheless, with few investors as passive members to the LLC, the LLC seems to be the desired entity type.
IPO Potential
An LLC is a creature of state law, and as such, it is bound by state specific rules that govern ownership in the entity. This means that when you want to take your business to the highest stages – like a national level, through an Initial Public Offering (“IPO”), it is beneficial to consider a C corporation format; as there really isn’t consistent treatment with respect to setting an LLC up for an IPO without first changing corporate form, as such an offering is a sale of ownership interests.
While it’s not entirely unheard of for an LLC to be publicly traded (ie: Facebook is an LLC and a publicly traded company – among many others), it is generally stated that it is not the best avenue for which to do so (although this can be arguable). As such, if you have aspirations of taking your business public at any point in the future, it’s better to go ahead and incorporate in a form that can be publicly-traded without reinventing the wheel. Hence, having readily available stock to offer (like a corporation) is normally the easier route but it is not the only one.
Benefits and Stock Options for Owners and Employees
When a C corporation is formed, shareholders in the corporation can also serve as employees. The corporation can then pay those individuals a salary that can then be deducted from corporate taxes, rather than paying shareholders dividends. These shareholder employees also receive fringe benefits, such as health insurance and reimbursement of medical expenses, which the corporation can also deduct, and the benefits are not taxable income to the employees. The availability of these options in the LLC form is limited.
Also, providing ownership incentives to employees in a C corporation is easy – simply provide them with stock, something that LLCs don’t have. It is possible to reward employees with a membership interest (in an LLC), but this is an awkward process at best. Offering employees an ownership stake in the company is a time-honored tradition to both reward past performance and incentivize future work.
Ultimately, the structure of a business entity will come down to how the organizers choose to run the business, what tax structure will be best benefit those goals and what future moves does the business wish to take. Certainly, you may not know what the future moves of your company will end up being; however, whatever entity you choose can always be converted in accordance with state law. Although the LLC is one of the most popular business entities chosen today, organizers should consider all options, as even the respected C corporation can be advantageous over newer forms in the right circumstances.