United States: Formation: C-Corporation vs. LLC For Your Startup – Which Should I Choose?

Last Updated: November 16 2018
Article by David M. Waizer

Q&A with David Waizer

In short, form an LLC if you're putting up a lot of your own capital or not seeking Venture Capital (VC) financing. Otherwise, save yourself time, aggravation, and money and form a C-Corp.

Q: Many first-time entrepreneurs wonder whether to form their startups as a limited liability company (LLC). Do you recommend this approach? What are the pros and cons?

A: This question comes up frequently because entrepreneurs often hear about the ease with which an LLC can be formed, the flexibility of the LLC structure, and that it can be converted into a C-Corp at a later date. Throw in some beneficial tax treatment, and it's easy to understand why people think forming their startup as an LLC is compelling.

What's less known by first-time entrepreneurs is that VC firms rarely invest in LLCs for contractual and tax reasons and LLCs are more complicated than people think.

Having been the General Counsel of an early stage venture firm for nine years, the venture capital part of me wants to tell them to form a C-Corp or it's unlikely they will get VC funding.

On the other hand, the lawyer in me understands that the answer is actually rather complex and recognizes that there are differing views on the topic. And in a few narrow circumstances, an LLC may be the preferred choice.

Q: What are some of the benefits of an LLC over a C-Corp?

A: There are some significant benefits to the LLC over a C-Corp, namely:

  1. Easy formation process
  2. Pass-through taxation
  3. Flexible structure

Formation

LLC: There are a number of differences between the formation documents of an LLC (Certificate of Formation) and a corporation (Certificate of Incorporation). State law dictates what is required to be included in each document.

Most states only require a few simple pieces of information to be included on a Certificate of Formation to form an LLC. Governance is handled by a contract between the members, called an Operating Agreement, rather than on the Certificate of Formation. Therefore, the hardest part of the LLC formation process is picking the name.

C-Corp: Unlike the LLC's Certificate of Formation, a corporation's Certificate of Incorporation (together with its Bylaws) is the primary governing document of the company.

Each state determines what information is required in a Certificate of Incorporation. While each state's requirements may be slightly different, this generally includes some basic information about the company and stock. Each state also has a set of comprehensive laws that deal with corporate governance. These laws contain a large number of "defaults" unless the corporation's Certificate of Incorporation or Bylaws provide differently.

Therefore, if you are willing to accept the defaults, your Certificate of Incorporation is relatively simple. However, you may not want all these defaults to apply to your corporation. Because the only way to change them is in your Certificate of Incorporation (or sometimes your Bylaws), forming a corporation requires more thought and attention than forming an LLC.

Taxes

LLC: Another, and probably the biggest, advantage of the LLC is that it is treated as a pass-through entity for tax purposes. This means that the LLC does not pay taxes on income. Instead any profits or losses "pass through" to the personal tax returns of the LLC owners.

In a very rudimentary example, if the LLC has losses of $10,000 in its first year and has two owners who each contributed $5,000 to own fifty percent of the LLC, each owner gets to take a loss of $5,000 against their income on their personal tax return. This is a great benefit, because most startups expect to lose money in the first few years and the owners get to offset income from other sources.

Therefore, from LLC income to your pocket, the cash only gets taxed once.

C-Corp: Simply put, C-Corps cannot compete with the tax structure of the LLC. C-Corps are taxed on income and incur losses the same as any other taxpayer. This results in what is called "double taxation."

Unlike an LLC distribution, if a C-Corp distributes some of the income it earned back to its shareholders (i.e., a dividend), the IRS taxes the shareholder on the dividend. Because the C-Corp pays taxes on the income and the shareholder pays taxes on the same money when received as a dividend, you have "double taxation."

As mentioned previously, because the LLC is a pass-through entity, in an LLC this money is only taxed once.

While corporations have a structure that allows for pass-through taxation called an S-Corp, these entities have a whole host of other issues beyond the scope of this article that generally make an S-Corp an unsuitable choice for most startups.

Structure

LLC: An LLC has an incredibly flexible structure. It allows entrepreneurs and investors to get very creative with respect to profit sharing, control, and exit strategies. Additionally, all the governing documents are located in one place – the LLC Operating Agreement.

C-Corp: The C-Corp structure is also flexible, although arguably not as flexible as an LLC's. The governance and contractual provisions contained in an LLC's Operating Agreement are spread across a corporation's governing documents and various agreements between its founders and investors. This requires tight integration and coordination to avoid inter-agreement conflicts.

Q: So, why wouldn't someone form an LLC?

A: At first blush, the benefits of an LLC appear to be rather compelling. But there are a number of reasons to avoid an LLC as your startup structure.

  1. Most Entrepreneurs Don't Realize Much of the Tax Benefit. Most first-time entrepreneurs do not invest too much of their own cash in their startup (often because they have limited funds). Because as a general rule you cannot deduct more losses on your tax return than cash you put into the startup, the benefit of the tax losses is limited.
  2. Most VC firms will not invest in LLCs. There are a number of reasons why VC firms cannot or will not invest in LLCs. Two of the main reasons are (i) VC funds are contractually prohibited from investing in them by their limited partners for tax reasons, and (ii) investors (and the entrepreneur) can have taxable income without receiving any cash. That's right – if the LLC makes money, the owners of the LLC must report income on their tax return – even if the LLC does not distribute any cash to them.
  3. LLCs are actually more complicated than C-Corps. Although the LLC has only one governing document, the LLC Operating Agreement is actually far more complicated than most people realize. These are not "off-the-shelf" documents. Because of complicated tax laws, a good LLC operating agreement will have many pages of legalese dedicated to addressing a host of tax scenarios and issues. Changes to the Operating Agreement are also often difficult and complicated (which means expensive).
    These changes get exponentially more complicated once you try to create profit sharing plans or equity plans for employees. Instead of explaining an option plan to them, you will have to explain the concepts of phantom income, membership interests, and capital accounts.
    Setting up C-Corps in the startup world, however, has become incredibly efficient. Most law firms with significant startup practices have created specialized documents and can have you up and running relatively quickly without incurring significant legal fees.

Q: Are there any other issues or considerations that should be made?

A: I am often asked, when would it be appropriate to form an LLC? It's appropriate to form an LLC for your startup when you are either (i) planning to invest a lot of your own money into your startup or (ii) not going to be seeking VC capital. If you do not meet one of these criteria, save yourself time and money and form a C-Corp.

Another question I am asked frequently is can't I start as an LLC and convert into a C-Corp? The answer is yes– you can convert your LLC into a C-Corp – in theory. In certain states and under certain circumstances, it is not too hard to convert from an LLC to a C-Corp. However, in practice, it can often get very complicated and expensive. Therefore, if you don't meet the criteria in Question 1 above, my guidance remains: go with a C-Corp.

Click here to read further Insights from Day Pitney

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
David M. Waizer
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions