As you start a new business, you may find it daunting to choose between an LLC and a corporation. It is always best to consult with an attorney to discuss your concerns and specific business, but these tips should help lay a foundation for you to answer this difficult question.
For less paperwork, choose an LLC!
A corporation must maintain more corporate documents (both up front and ongoing) than an LLC. When forming a new LLC, the only document required is its Articles of Organization. However, new LLCs should not begin operations without a written Operating Agreement in place, otherwise the state will imply that the LLC has an oral operating agreement dictated by the default LLC rules (which can and should be modified through a written Operating Agreement). Corporations, on the other hand, must file Articles of Incorporation, hold and memorialize annual board meetings and annual shareholder meetings where decisions can only be made if the meetings have quorum (lawyer-speak for a specific majority), and keep the records of these meetings (meeting minutes) at the corporation’s head office. Corporations are also encouraged to have bylaws (an internal governing document for the organization), issue stock certificates (or record stock ownership and transfers on an internal ledger if the corporation opts for uncertificated shares), and enter into shareholder agreements. With all this extra maintenance for a corporation, it typically takes less time to create an LLC, which means you can pay your lawyers less, too!
For the opportunity to seek investment, choose a corporation!
There are more intricacies involved in investing in an LLC than in a corporation, which is one of many reasons professional investors favor investing in corporations over LLCs. LLCs sell membership interest in their company, which means interest is sold as a portion of the whole. For example, if there are currently two founders, each with a 50% membership share of the company, one or both of the members will have to give up a portion of their share in order to admit a third person (e.g. an investor) into the ownership of the LLC. Now this investor owns a piece of the company and will receive a K-1 statement each year indicating his or her share of the profits and losses from the company. He or she will file the K-1 on his or her personal income tax return annually, and will have to pay taxes on any profits from the business, even if the business decides not to issue profit shares to its owners (i.e. if it chooses to reinvest those profits in the business). Many investors choose not to invest in LLCs because of the additional paperwork obtusely complex partnership taxation rules.
When forming a new corporation, the founders choose an arbitrary amount of shares to initially authorize (typically in the tens of millions depending on how the state treats shares for state taxation purposes). The founders must choose how many to keep for themselves, how many to retain for investors, and how many to divvy up to new employees. Typically, not all of the authorized shares will be issued at the start, which allows for a pool of shares for use down the road. When a corporation sells shares to an investor, the company gets the money that the investor put in and the investor gets a certain number of shares, representing his or her ownership stake in the business (with his or her fingers crossed that the company will succeed and the value of those shares will increase). The investor will pay tax on his or her shares if the value increases in a given year (called a capital gains tax), or if the company pays out a dividend to its stockholders. Many investors prefer the simplicity and passiveness of owning stock in a corporation and avoiding the tax complications that come with buying membership interest in an LLC, and most venture funds simply will not invest in LLCs for this reason.
For easier taxation guidelines, choose an LLC!
Assuming the LLC opts to be treated as a partnership or an S-Corp for tax purposes, LLCs are taxed just once. As noted in #2, owners report and pay taxes on their personal tax returns based on their allocated share of profits. There are no business taxes to pay. Corporations, however, are taxed twice (unless they opt for S-Corp status). First, corporate tax is paid on the income flowing into the business. Then, when profits are distributed as either wages to employees, or dividends to shareholders, that money is taxed again on the personal tax return of the receiver. However, one advantage to the two-prong corporation tax is the ability to leave profits with the company, thereby only subjecting it to the lower corporate tax rate. This means the money is not distributed as wages or dividends, therefore avoiding that second level of taxation. While this can be very advantageous, especially for a highly successful company, it can cause a lot of unnecessary confusion for a small company that intends to stay small.
For more ownership flexibility, choose an LLC!
In the company’s documents, LLC founding members can dictate many operational specifics, such as ownership interest and the company’s perpetuity. LLC members can own disproportionate equity shares by simply specifying this in the operating agreement. It is very easy, for example, to give a member 80% ownership when his or her capital contribution only amounts to 50%. This means that the member provided half of the business’s equity, and is now receiving 80% of its profits. Corporations, on the other hand, do not have this flexibility with its shareholders — the ownership percentage is always proportionate to the equity contributed.
Owners beware! An LLC might self-terminate if one member dies or leaves the business, even if the other members would like to keep the business going, unless the LLC specifically chooses perpetuity. Declaring perpetuity in the articles of organization and the operating agreement, and specifically indicating that the LLC will not automatically dissolve upon the dissociation of any one member, can easily adjust this default rule.
For protection against your personal assets, choose either!
Both an LLC and a corporation will protect your personal assets from your business’s debts and liabilities. Your liability to repay the business’s obligations is limited to what you have invested in the company, never more (provided you observe all corporate formalities and don’t give personal guarantees for loans). Therefore, your personal assets are protected from any failure or liability obtained on behalf of your LLC or corporation, so in either case you do not need to worry about company debts taking a bite out of your personal life.
BONUS TIP: For starting up a professional services company, choose corporation!
“Professional services” means any type of professional service, lawfully rendered pursuant only with a license, certification, or registration authorized by the Business and Professions Code, the Chiropractic Act, or the Osteopathic Act. Legally, many professional services companies must incorporate.
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- Understanding the S Corp
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Photo Credit: Phillip Harder