When you are starting your business, one of the most important issues you’ll need to address is how to structure your legal entity. As with many legal questions, there is no one-size-fits-all answer here, we need to look at the context of your specific business and choose the entity type that will work best for you. As a general matter, all founders should look to establish a formal legal entity to get the protection afforded by limited liability, amongst a variety of other potential benefits. For most of our clients that would mean setting up as either a Limited Liability Company (commonly referred to as an LLC) or a Corporation.
If you plan on raising money from investors, in particular companies that intend on raising venture capital, a C-corporation (or C-corp for short) is the preferred entity structure. There are a variety of reasons for this. C-corps have stock, which the company will issue to its shareholders (which of course will include its investors), and that stock is much more easily transferable for investors than interests in an LLC. C-corps also have a well-understood and standardized structure for the distribution of incentive equity, typically in the form of options to purchase stock, which can be used to attract, incentivize and retain key talent. Also, many investors, especially VC investors, are focused on a company exit in order to cash in on their investment, either through an IPO which is impossible to do as an LLC, or by the company getting acquired, which can also be much more complicated when dealing with an LLC.
If you are starting a business that you believe will be smaller in terms of number of employees and grow in a more organic fashion, maybe with a couple initial investments to get off the ground, but not the type of high-growth, repetitive investment cycle that is common in the world of venture capital, then an LLC or S-corporation might be right for you. The major benefit of using these entity types is the tax savings – LLCs and S-corps can be taxed as “disregarded entities” which means that the only tax hit the company and its owners will be on the personal tax returns of the company owners. Owners of LLC also have the benefit of passing through company losses as a way to offset their individual tax returns. C-corps on the other hand cannot pass losses through to its owners and have to deal with double-taxation, meaning business income gets taxed once at the corporate level, and then shareholders get taxed again on their personal tax returns if they receive dividends from the business. The thing to keep in mind with LLCs, however, is that even though the initial setup and structure may seem simpler than that of a C-corporation, the administration of an LLC and in particular the tax issues for both the company and its members and employees can end up being a lot more complex, time consuming and cost intensive than you might think. On top of that, it’s not always easy, and can be expensive, to convert an LLC to a C-corp if you decide down the line that you made the wrong entity choice at the outset.