Before founders can kick-start operations, bring in customers, or engage investors, they are advised to create a legal entity to pursue such milestones. Establishing a legal entity serves several key purposes: the founder can limit his or her liability; present a professional, commercial organization behind his or her idea; and fundraise via issuance of ownership interests. Choosing which entity to select presents the first of many questions a founder will need to consider.
The most popular types of entities that founders select for their companies are limited liability companies (LLCs) and corporations, with two types of corporations to choose from: C-Corporation (C-Corps) and S-Corporation (S-Corp). The main differences among these entity choices are tax treatments, ownership requirements, and formalities and duties that are imposed on founders and fiduciaries. These differences should be carefully considered in determining the choice of entity that best fits the founders’ needs.
Taxes. Corporations can elect two different types of tax classification – classification as an S-Corp or as a C-Corp. The names are derived from the section of the tax code that governs the taxation of such entities – 26 U.S. Code Subchapter S and 26 U.S. Code Subchapter C. Similarly, depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a (i) corporation for tax purpose -- similar to a C-Corp, with taxation both on corporate profits as well as stockholder/equity holder dividends, or (ii) as a partnership for tax purpose -- similar to an S-Corp with pass through taxes and more flexibility than a C-Corp in how its profits are distributed.
Qualified Small Business Stock. In addition, certain C-Corps are eligible to issue qualified small business stock (QSBS) pursuant to Internal Revenue Code Section 1202, which is eligible for a number of tax benefits, including an exclusion from capital gains taxes of up to 100% of the taxable gain. Such exclusion applies to the greater of $10,000,000 or ten times the taxpayer’s adjusted basis in the stock. S-Corps and LLCs, on the other hand, are not eligible for QSBS issuances.
Ownership. C-Corps and LLCs may have an unlimited number of equity holders -- called “stockholders” for corporations, and typically “members,” “unitholders,” or “shareholders” for LLCs, depending on the term used in the LLC’s governing operating agreement. S-Corps, on the other hand, are less flexible, typically allowing no more than 100 stockholders. An S-Corp’s shareholders are limited to U.S. citizens or residents, as well as certain tax-exempt entities, and generally may have no entity owners. C-Corps and LLCs have no such ownership restrictions.
Equity Classes. C-Corps and LLCs may have multiple classes of stock, while S-Corps may have only one class. As such, an S-Corp may not issue a class or classes of preferred stock featuring the types of powers, rights, and preferences which may be attractive to investors.
Liability. S-Corps, C-Corps, and LLCs all provide limited liability protection to their equity holders.
Formalities and Duties. LLCs are not statutorily required to hold annual meetings or keep formal records and may tailor the provisions of the operating agreement governing the company to its specific needs. Corporations must adhere to more formal requirements such as holding annual meetings, delivering notices of certain actions and meetings to stockholders, and keeping corporate minutes. In some states, the managers of an LLC may even disclaim any fiduciary duties, while corporations may not disclaim fiduciary duties to which corporate directors and senior officers are bound.
After working through the key differences between LLCs, C-Corps, and S-Corps, founders often eliminate the S-Corp from consideration due to inflexibility on equity ownership, 1202 ineligibility, and the requirement for a single class of stock. As between an LLC and C-Corp, the flexibility of equity ownership and flow through tax benefits make the LLC attractive to founders, particularly if the entity is expected to be extremely profitable; however, the QSBS benefits afforded only to C-Corps are often the driving factor for investors in requiring that the entity choose C-Corp as the structure. Fortunately, the founder’s initial decision on structure is not irreversible, with founders often starting with an LLC and converting to a C-Corp at the time of an investment to meet investor requirements so long as 1202 conditions can still be met, which is often the case with early companies.