Guide to Legal Entities for Start-Ups

Partnership, LLC, S Corp, or C Corp?

I. Partnerships

Most businesses start as sole proprietorships or partnerships. Partnerships are either general or limited or general for a specific purpose. Any limited partnership may involve securities issues. The main advantage of the partnership entity is that it can formed with a letter agreement. It actually can be formed with even less than that, but it is best to put business undertakings in writing.

Most partnership soon evolve into LLCs to take advantage of limited liability. Two of the most common early legal business structures are the limited liability corporation (LLC) and the S Corporation. There is also the C Corporation. An LLC offers advantages over all of them at the outset.

II. LLCs

An LLC allows a business to set up an ownership structure that makes sense for liability and tax purposes. Unlike an S Corp in which the share structure mirrors the amount invested by each shareholder, an LLC has flexibility. This is important as profits flow through an LLC and hence are taxed to the owners. Profit distribution does not have to mirror percentage investment in the company.

1) Transfer of Ownership

In an S Corp, shares can be sold, gifted or willed to others, creating changes in ownership structure and possible leadership and direction issues. In an LLC, if it is dissolved, say upon the bankruptcy or death of an owner, or due to business disagreements, some owners can regroup and simply set up a new LLC.

2) Less Paperwork

All corporations, including S and C Corps, are required to hold regular shareholder meetings and memorialize the matters covered in such meetings. A board of directors makes decisions by means of formal documented resolutions. An LLC has no need for minutes, resolutions or meetings. This reduces time spent on administration paperwork as opposed to strategic planning and execution of the business plan.

3) Lower State Filing Taxes

Although LLCs pay no federal income tax, state filing taxes are paid. The annual state filing tax is less for LLCs than it is for S Corps. In some states, LLCs with only one or two members do not even pay an annual state filing tax. The annual filing tax is always lower than for S Corps.

4) Simple to Set Up

Forming an LLC is easy. The fees for setting it up are generally low. You gain limited liability and you get pass-through tax treatment without the "double taxation" of a C Corp.

Many businesses start out as LLCs and then change to a C or S corporations. Keep reading.

III. S Corporation

The S Corporation is a popular structure for small businesses in part because the company is taxed like a sole proprietor or partnership. The company itself does not file its own taxes; all company profits and losses are "passed through" and reported as personal income of the shareholders, just as, in the case of an LLC, to the members.

1) Business Formality

S Corporations involve compliance obligations which can be initially burdensome for a founder. If you incorporate as an S Corporation, you need to set up a board of directors, file annual reports, make other business filings, hold shareholder’s meetings, keep records of your meetings, and operate at a higher level of regulatory compliance. LLCs use an informal operating agreement. If you want less red tape and formality, the LLC is for you, at least in the first days.

2) Who Can Be a Shareholder?

The S Corp cannot have more than 100 shareholders. Obviously, this is not relevant to most start-ups. All individual shareholders of an S Corp must be U.S. citizens or permanent residents. Also, if you want an LLC to be a shareholder you cannot form an S Corporation and you probably should opt for an LLC until you are ready to be a C Corporation.

3) Income Allocation

With an LLC, income and loss can be allocated disproportionately among the owners whereas in an S Corp income and loss are assigned to each shareholder based on their pro-rata shares of ownership. This can be important. Say Steve and Mike open an auto dealership as co-owners. Mike soon needs to focus on other things and Steve does more and more of the work. They decide Steve should take 65% of the profits. With an LLC, everything is good; the partners are taxed pursuant to the terms of their LLC Operating Agreement. But not with an S Corporation. Since Steve and Mike are 50% owners, each will be allocated 50% of the corporation’s income.

4) Pass-Through Losses

With LLCs and S Corporations, members and shareholders apply company losses to their personal incomes. In an LLC, for instance, members can add the amount of the mortgage to their basis for the purpose of computing a loss.

5) Class of Stock

In an S Corporation, all shareholders own one class of stock. An S Corporation can have voting and non-voting shares but cannot have common stock and preferred stock. (See discussion below regarding C Corps). In an LLC, priorities and preferences are allowed, and you can have different membership classes. You cannot offer common and preferred stock classes in an S Corporation.

6) Reinvesting Profits

As pass-through entities, individual owners of an S Corporation or an LLC are liable for all taxes owed on profits — whether that money is retained in the company or put in their wallets. For example, if Mike owns 10% of an S Corporation and that company makes $1,000,000 in profit, Mike needs to report $100,000 in income on his tax return. This is the case whether or not $100,000 was put in his bank account. This is known as “phantom income.” If you plan on keeping money in the company and would prefer not to have be personally taxed on this money as a shareholder, you should consider the C Corporation over both the LLC and S Corp.

7) Private Placement Funding

If your company is considering raising private equity or venture capital down the road, institutional alternative funding sources will likely demand a C Corporation. Your business does not need to start as a C Corp, but if you are considering raising serious private capital you will need to convert the business to a C Corp at some point.

This conversion will require additional filings and fees within your state. This is why some entrepreneurs consider the S Corp the default option, since converting an S Corp to a C Corp can be done in a day with a single tax form.

IV. C Corporation

1) LLC vs. C-Corporation Taxation

The most obvious problem with C Corporations is that they do not offer the pass-through advantages that LLCs and S Corporations do. The corporation will pay tax on any profits and employees pay taxes on salaries, and if there are any profit distributions by means of dividends owners will be taxed (again). The tax code is not friendly to a C-Corporation that wants to provide profits to shareholders. If those shareholders are also employees, there will three different points of taxation!

LLCs look like they have only one point of taxation but in reality there is a second point. There is self-employment tax and income tax. Paying self-employment taxes is still better than paying C Corp taxes because the C Corp needs to pay an employment tax on salaries (the same as a self-employment tax).

2) Hold profits in or not

With the C Corp you can hold profits in the corporation rather than pay them out. If you are profitable, you will want to hold profits in and pay yourself a minimal salary. If you expect to experience losses, as is usually the case in early stage companies, the LLC has advantages in that LLC loses can offset other income. A C Corp will carry those losses (for credit against future profits) but the owner, as a tax-paying employee, does not get to make use of them. He or she will have additional W-2 income.

3) Ownership structure of LLCs

The systemic drawback to LLCs is the problem of how you deal with the ownership structure.

LLCs do not have shareholders and shares of stock; instead they have "members" and "units.” In an LLC each member is the same as e very other members. Everyone is working under the same operating agreement: investors, the founder or founders, any employees who have been given (or expects to be given) ownership – all are the same; there is no difference between them.

4) Ownership structure of C Corps and Flexibility

C Corporations can issue different classes of stock. A founder might have preferred stock while employees and investors have common stock. Those classes can be subdivided. First investors can get "Series A Preferred Stock" with certain rights while later investors are given "Series B Preferred Stock" with different rights. C Corps also allow for ordinary stock options for employees—ownership in exchange for their loyalty to the company--while the owners hold on to “founders stock.” Also, select vendors can be given stock warrants in exchange for providing discounted services.

5) C Corp stock options

If you ask an investor to put in money at $100 per unit and then you give him 1,000 units, you have subjected that employee to a tax hit. The IRS will say that you “paid” the employee $100,000 and he owes income tax at ordinary income rates. So your employee is out, say, perhaps $30,000 in taxes.

But with a C Corp, you can create a stock option plan to give to-be-vested ownership to employees. The option price must be equal to the fair market value of the underlying class of stock at the time the option was granted. The company will grow (we are assuming) so by the time the stock vests it will be worth more than when it was granted. The employee will have to pay tax on the gain when he exercises those options, as short term capital gain, not ordinary income.

In a C Corporation all classes of stock are usually not created equal and, therefore, are not priced the same. The preferred shares can have benefits that make them much more valuable.

So what to do?

Private Placement Advisors starts new clients with an LLC. After success and the founder(s) want to grant stock options to new (or old) employees, or outside investors, we convert to an S or C Corporation. When you are talking to major investors and/or dealing with employee option pools, C Corporations are usually best. When it is you and one or two partners, use an LLC. But be careful with that LLC. You do not want to end up with a large number of investors who have invested at different times -- with no flexibility in how those shares/units are priced or structured.

Private Placement Advisors LLC is a group of experts who draft and file disclosure and offering documents for review by regulators and investors.

We are JOBS Act experts who curate crowdfunding and peer-to-peer platforms, write clients’ pitch decks, write and file clients’ offering documents, and assist clients in investor presentations.

Managing partner Douglas Slain, a Stanford Law graduate with big firm experience, authored the 10-volume Private Placement Handbook Series.