Should I set up a limited liability company (LLC) or a corporation? This is both an excellent question and perhaps the most common question asked by start-up small business owners. While both entity structures offer critical personal protections, they each have advantages and disadvantages which entrepreneurs must understand before deciding which corporate format is best for their business.
The most compelling reason to formalize your business’ structure is to ensure that personal assets are protected from business liability. Both the limited liability company and corporation structures afford business owners this protection. Barring exceptional circumstances, both structures limit personal liability to the amount of investment in the business. However, for the most part that’s where the similarity ends.
Limited liability companies are typically preferred by business owners that seek flexible management structures and simplified tax reporting obligations. While the day-today operations of corporations are managed by its corporate officers, those officers are appointed by a board of directors whose members are elected by the corporation’s shareholders. Limited liability companies do not have shareholders, but rather are owned by its members or a sole member, and unlike with corporations, there is considerable flexibility in determining each member’s percentage ownership interest.
Limited liability companies may be member-managed or manager-managed. In a member-managed LLC, all of the member owners participate equally in the management of the limited liability company. For LLC owners interested in approximating the management structure of a corporation, the manager-managed structure may be the best option. Under a manager-managed structure, the members designate an individual or individuals to oversee the affairs of the business and the individuals need not be members of the LLC. The non-managers effectively become passive investors not involved in day-to-day business operations.
By forming as a limited liability company, business owners simplify tax reporting obligations by eliminating what is commonly referred to as double taxation of corporations whereby income taxes are paid twice on the same source of income. Corporate income is taxed both at the corporate level and at the personal level when paid out as salary or service fees. LLC income, by contrast, is only taxed once as profits are distributed or “passed through” to owners as personal income and the business itself is not taxed.
Despite some of the apparent shortcomings of the corporation format highlighted above, the corporation structure is often more appealing to business owners seeking to attract outside investment or issue stock options to employees. Sophisticated outside investors may be hesitant to invest in LLCs due to their limited corporate governance requirements and uncertainty regarding the application of corporate principles to limited liability companies. Corporation law is well established, making the consequences of corporate decision-making highly predictable.
In addition, many venture capitalists are precluded from investing in LLCs due to tax law complications as well as restrictions posed by governing documents. Venture capitalists are by nature focused on liquidity events in order to maximize their return on investment. Accordingly, venture capitalists typically invest in companies that are candidates for either an initial public offering or acquisition by a larger established entity. Both of these scenarios pose significant obstacles for limited liability companies due to the potential difficulty in transferring partial ownership in an LLC.
For business owners that find attributes of both limited liability companies and corporations to be compelling, there is a hybrid approach. By establishing a corporation and then making an S corporation election with the Internal Revenue Service, a corporation is treated much like an LLC with income passed through to its shareholders. However, S corporations are permitted to issue only one class of stock and are required to have 100 or less shareholders, all of whom must be U.S citizens or documented resident aliens and not partnerships or corporations.
Although S corporation election may simplify tax treatment for the small business owner, it also limits access to investor capital due to the restrictions on who may be shareholders. The requirement that shareholders be U.S. citizens or documented resident aliens and not partnerships or corporations rules out both foreign investors and most domestic venture capitalists which are generally set up as partnerships. Because S corporations can only offer common stock, they are precluded from issuing preferred stock which is favored by venture capitalists as it typically pays higher dividends and prioritizes holders upon a liquidity event. As with LLCs, the pass-through tax treatment of S corporations is also problematic for venture capital entities.
In addition to the considerations summarized above, small business owners must determine what state is best for the formation of their entity as filing, reporting, disclosure, fee and other requirements vary from state to state. While many states permit conversion from one entity type to another, this can be a complicated process with tax implications and should be avoided if possible. Selection of the proper entity format and state of formation should always be done in consultation with legal, financial and tax advisors. Please contact Cramer & Anderson Business, Corporate and Commercial Law Partner Neal White at (860) 567-8718 for additional information.