Choosing a business entity is about selecting the type of business that accomplishes the founders’ legal goals at the lowest tax cost. Compared to corporations, LLCs usually accomplish the founders’ goals in the most tax-efficient manner.
Accomplishing the Founders’ Legal Goals …
For accomplishing the founders’ goals, LLCs more options than corporations. LLCs offer the following advantages over corporations:
- Protection Against Outside Liability. Most founders form business entities for liability protection. Assuming they are properly organized and operated, both corporations and LLCs protect the owners from the debts and obligations of the business (inside liability). But unlike corporations, LLCs also provide charging order protection against debts of the owner (outside liability).
- Flexible Management. LLCs can choose their management structure. LLCs can be member-managed or manager-managed. With proper drafting, an operating agreement can even provide a management structure that functions like the board of directors of a corporation.
- Fewer Corporate Formalities. Corporations require more care and feeding than LLCs. Although there is variation between the states, corporations must usually have annual meetings, keep minutes, and keep their registration current with the state. LLCs require less corporate formality and are generally easier to maintain. The lack of required formalities provides LLCs with more protection from veil-piercing
LLCs are the most flexible form of business. With proper planning—including a well-drafted operating agreement—an LLC can accommodate almost any deal that the founders can imagine. There is nothing that a corporation can do that an LLC cannot, but LLCs can do many things that corporations cannot. This flexibility makes LLCs a better choice than corporations for accomplishing most legal and business goals.
… At the Lowest Possible Tax Cost
Tax optimization is mostly about avoiding double taxation on business income. Although there are rare situations where double taxation is unavoidable, most founders can save taxes using a pass-through entity that avoids double taxation.
LLCs can choose their tax structure. By default, the Internal Revenue Code either disregards the LLC for tax purposes (if one owner) or treats it like a partnership (if multiple owners). But the LLC can elect out of this default classification. An LLC can be taxed as a C corporation or—if it meets the eligibility requirements—as an S corporation. Because an LLC can be taxed as a corporation, there are no tax benefits available to corporations that are unavailable to LLCs.
Although LLCs can elect to pay higher taxes as a C corporation, most founders want their LLC to qualify for pass-through treatment under the Internal Revenue Code. There are two ways that LLCs can be classified as pass-through entities:
- LLC Taxed Under the Default Classification. The default LLC tax classifications—disregarded entity for single-member LLCs and partnership for multiple-member LLCs—both avoid double taxation. Pass-through treatment applies automatically. No special steps or elections are required.
- LLC Taxed as an S Corporation. An LLC that meets strict eligibility requirements may elect to be taxed as an S corporation. Because S corporations are also pass-through entities, electing to be taxed as an S corporation allows the LLC to avoid double taxation. LLCs taxed as S corporations are a popular choice for self-employed individuals that want to save self-employment taxes.
LLCs also provide tax-planning opportunities beyond avoiding double taxation. For example, LLCs taxed as partnerships can adjust the tax basis of partnership assets. 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 makes the business more attractive to a buyer and has real economic value to the seller.
When a Corporation May Be a Better Choice Than an LLC
Given everything said above, one may ask why anyone would ever form a corporation instead of an LLC. The answer is that there is one specific scenario where corporations are still the preferred entity: High-growth technology startups that are seeking investment.
Historically, venture capitalists and other institutional investors have required startups to be organized as corporations as a condition of investment. Although investors are warming up to LLCs as investment vehicles, most still prefer to invest only in corporations. See our discussion of high-growth technology startups for more explanation.
The Wait-and-See Approach to Choosing a Business Entity
The path to success differs from startup to startup. Many founders are focused on testing their ideas, finding the right market fit, and obtaining customers. They do not know whether they will want to keep their equity by bootstrapping the company (in which case an LLC would be most beneficial) or whether they will seek funding from investors (in which case a corporation would be most beneficial). These founders may balk at being forced into a tax-inefficient corporation just to launch the business.
As explained in How to Convert an LLC to a Corporation, it is relatively easy to convert an LLC to a C corporation in a tax-free transaction. But the reverse is not true. If the business starts as a C corporation and succeeds, and the founders later decide to convert to an LLC to avoid double taxation, there is no way to do so without paying additional taxes.
Founders that are unsure whether they need a corporation to attract venture capital financing can use a wait-and-see approach by forming an LLC as the initial business entity. Forming as an LLC provides a flexible, tax-efficient business structure to start and grow the business while preserving the option to convert to a corporation later. See our discussion of the wait-and-see approach for more explanation.