Many first-time business owners are confused about the right form of legal entity for their new business. Some have been told that they must organize as a corporation to attract investors. Others have been told that all businesses should be formed as LLCs. Still others wonder if they should form a business at all. This article discusses the reasons why LLCs are the better choice for most new businesses.
Start with the Purpose
The business entity you choose should be the one that is best suited for accomplishing your goals. That statement seems obvious, but many new entrepreneurs miss it. They jump straight to the “how” without ever addressing the “why.” As with many things, determining the purpose (the why) is an important part of determining the proper means for accomplishing the purpose (the how).
There are many reasons people form LLCs or corporations. These reasons include:
- To limit owner liability for debts and obligations of the business and to protect other owners from business risk associated with co-ownership;
- To provide clear rules for the organization and operation of the business, including the rights and obligations of the owners;
- To achieve tax savings by organizing business operations through a tax-efficient structure;
- To protect the anonymity of the business owners by conducting the business through its professional name;
- To add professionalism and credibility when dealing with third parties, including investors and other stakeholders in various business deals;
- To obtain valuation discounts to reduce estate and gift tax liability;
- To isolate liability for an asset to the company—or, in the case of a series LLC, the series—that owns the asset so that other assets of the business are not at risk.
The right business structure for a real estate investor that plans to buy and hold properties will drastically differ from the right business structure for a startup on the verge of obtaining early stage investment.
Similarities Between Corporations and LLCs
Before discussing the differences, it is worth noting that both LLCs and corporations can accomplish some of the same business objectives. These objectives include:
- Limited Liability – Assuming they are properly organized and operated, both corporations and LLCs protect the owners from debts and obligations of the business (inside liability). LLCs provide additional protection against debts of the owner (outside liability), but the inside liability protection offered by both forms of business is the same.
- Formation Process – Both corporations and LLCs are formed by filing documents with the Secretary of State or other appropriate state agency. While the preparation of the governing documents can differ, the actual formation process is roughly the same.
- Perpetual Business Duration – Both LLCs and corporations can have perpetual duration and can outlive their owners. This allows for the creation of a valuable asset that can pass down to the next generation.
Why LLCs Are Usually the Best Choice
There is one very specific scenario in which a corporation is a better entity choice than an LLC. That scenario is discussed below. For most new businesses, LLCs are the best form of business. Here’s why:
- Protection Against Outside Liability – Most people form LLCs for liability protection. LLCs provide more protection than corporations because they provide charging order protection against outside liability.
- Flexible Management – LLCs are, by far, the most flexible form of business. A well-drafted operating agreement can achieve almost any business goal.
- Tax Flexibility – LLCs can choose their tax structure. Although an LLC is taxed as either a sole proprietorship (if one owner) or partnership (if two owners) by default, an LLC can elect to be treated as a C corporation or S corporation if it qualifies. This means that there are no tax benefits available to other entities that are unavailable to LLCs.
- Fewer Corporate Formalities – Corporation generally require more care and feeding than LLCs. Although there is variation between the states, as a general rule, corporations must have annual meetings, keep minutes, and keep their registration up-to-date with the state. LLCs require less corporate formality and are generally easier to maintain.
- No Double Taxation – Owners of C corporations are taxed twice on their earnings: The corporation pays tax when it earns the income and the owners pay tax when the income is distributed to them. If the LLC doesn’t elect to be treated as a corporation, income from the LLC is only taxed once, when earned. It is not taxed again when it is distributed to the owners.
- Basis Step-Up – LLCs taxed as partnerships can to adjust the tax basis of partnership assets if the partnership makes an election under Code § 754 (754 election). The ability to step up the basis makes the business more attractive to a buyer. In business acquisitions, the value of the basis step-up can be separately modeled and added to the purchase price. If the company is profitable, this increase has real economic value to the seller.
- Easier to Convert – As explained below, if a business starts as an LLC that is taxed as either a sole proprietorship or a partnership, it is relatively easy to convert that business to a C corporation in a tax-free transaction. The reverse is not true. If the business starts as a C corporation and is successful, and if the founders decide to convert to an LLC to avoid double taxation, there is no way to do so without paying additional taxes.
Of these reasons, double taxation is perhaps the most significant. The multiple layers of income tax have real economic consequences to the owners and can reduce the overall value of the business. Although eligible corporations can make a subchapter S election to avoid double taxation, S corporations come with several limitations that make LLCs a better choice:
- Number of Owners – Unlike S corporations, LLCs can have an unlimited number of owners. S corporations can only have up to 100 shareholders.
- Owners Need Not be U.S. Citizens or Residents – LLCs may be owned by foreign owners. S corporations may only be owned by U.S. citizens or residents.
- Multiple Classes of Equity – Unlike S corporations, LLCs can issue multiple classes of equity that differ in economic rights. S corporations may only issue one class of equity.
- Business Owners – LLCs may be owned by any type of owner, including a business. An S corporation may only be owned by individuals, certain qualifying trusts, and estates.
For these reasons, LLCs are more tax-efficient and operationally flexible than other forms of business entities.
When a Corporation May Be Appropriate
There is one situation where a corporation can be a better choice than an LLC: If the company is a high-growth technology startup. The business plan for high-growth startups is to raise capital, reinvest it in the business, grow fast, grant equity incentives if needed, and have a successful exit (through being acquired or going public). Either the startup will succeed at that goal or it will cease to exist. There is no middle ground.
For decades, the conventional wisdom for high-growth startups has been fairly uniform: Form a Delaware C corporation. Choose Delaware because it has a well-established body of corporate law that is familiar to serious corporate attorneys. Choose C corporations, because that is what experienced venture capitalists and their attorneys will require before they write checks. Attorneys that do a high volume of startup and venture capital work dispense this advice without question, and there is truth to it. A corporation can make sense if the business is a high-growth startup with these characteristics:
- The business plans to use equity to compensate employees or service providers;
- The business knows that it will raise capital using various equity rounds from investors that will require the business to be a C corporation; and
- The company will not earn a significant profit for its shareholders, but will instead reinvest all profits into the growth of the business.
Even in the high-growth technology space, some founders are shying away from the one-size-fits-all approach and choosing to form LLCs instead of corporations. Forming an LLC can help these startups get essential documents in place without the expense and hassle of forming an out-of-state corporation that they may never need. Starting as an LLC can keep overhead costs and taxes low, allowing the company to spend its resources developing its core product and attracting its first customers.
Unless the founders know that they will attract outside investment, starting as an LLC keeps options open. If the company is profitable, it will pay less taxes on its income. And, at least at the initial funding stage, the fact that the company is organized as an LLC should not be a deterrent to angel investors. If the company attracts outside investors that require the company to be organized as a C corporation, conversion is relatively easy to do.
Converting from an LLC to a Corporation
Most states—including Delaware—have a relatively simple mechanism for converting an LLC to a corporation. These “statutory conversion” laws automatically transfer all of the debts assets of the old LLC to the new corporation. There is no need to form the new corporation or dissolve the old LLC. The statutory conversion treats the new corporation as a continuation of the old LLC. The Secretary of State has pre-printed forms that can be used to convert the business.
From a tax perspective, converting from an LLC to a C corporation is relatively painless. The IRS treats a statutory conversion as an assets-over transfer where the LLC contributes its assets to the corporation in exchange for stock, then immediately liquidates and distributes the stock to the members. Under the rules governing contributions to corporations, the transaction is not a taxable event, as long as the former LLC members own stock in the new corporation that is at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock.
Conversion from a corporation to an LLC is not so easy. When a corporation converts to an LLC, the IRS treats the transaction as though the corporation liquidated its assets (in a taxable sale), then distributed the net proceeds to its shareholders (in a taxable dividend). Under these rules, each step of the transaction triggers the double taxation that is characteristic of corporate taxation. The corporation pays tax on the deemed sale of its assets, and the shareholders pay tax on the deemed distribution to the shareholders.
Because LLCs are a more flexible and tax-efficient form of business, and because the tax cost of converting from an LLC to a corporation is much lower than the tax costs of converting from a corporation to an LLC, an LLC is the preferred business entity for most new businesses.