Forming an LLC or Corporation - Part 1: Understanding Your Options for Choosing a Business Entity Type

With many business entity options to choose from, picking a legal form for your business can be a daunting undertaking.  In this blog post series, we explain the basics of choosing between and then forming two of the most common types of business entities; the corporation, and the limited liability company (“LLC”).

Corporations Basics

There are three types of corporations, the C corporation, the S corporation, and the benefit (B) corporation. The most common corporate forms are the C and S corporations, which will be discussed in this blog series. 

What Is a C Corporation?

A C corporation is a very common type of business entity. The main features of this entity type are that C corporations issue shares and are owned by shareholders, provide shareholders with limited liability, are subject to “double taxation,” and provide significant flexibility in terms of organizing different classes of shares and ownership rights. 

Here is some more information about these key features:

Ownership

Ownership of a corporation is divided according to the number of shares a shareholder has. For example, if a corporation that sells dwarf apple and pear trees, called “Lil Fruities, Inc.” (“Lil Fruities”) has issued a total of 1,000 shares, a shareholder who holds 100 shares owns 10% of Lil Fruities.

In addition to the number of shares, one also needs to look at the types of shares issued by a given corporation to determine the ownership rights of different shareholders. Expanding upon the example above, say Lil Fruities has issued two types of stock: Class A has voting and economic rights, and Class B has economic rights only. If there is an equal number of shares in both classes, and one shareholder has 10% of the Class A shares, while another holds 10% of the Class B shares, both have an equal right to Lil Fruities profits, but only the Class A shareholder may vote on matters such as selection of the Corporation’s officers.

Governing Documents

A corporation is formed by filing articles of incorporation with the State Corporation Commission or similar state governmental agency. The corporation can also adopt bylaws to establish rules for how the business will be run.

Limited Liability

Shareholders in a corporation have limited liability. This means that if the corporation is sued or can’t pay its debts, the shareholders will not be held personally liable, and creditors can only recover assets held by the corporation itself. There are some exceptions to this rule (e.g. corporate veil piercing), but discussion of these exceptions is beyond the scope of this blog post.

Double Taxation

C corporations pay taxes on income at the corporate level, but employees and shareholders must also pay taxes on their salary and any other distributions or compensation received from the corporation. This taxation at the corporate and personal level is called “double taxation.”

What is an S Corporation?

The “S corporation” is really a corporation with a special tax status elected with the Internal Revenue Service (IRS) rather than a distinct business entity. An S corporation is structured similarly to and follows many of the same rules as a c corporation. However, there are a few key differences:

Limits on Ownership

Unlike C corporations, S corporations may have no more than 100 shareholders. Additionally, shareholders of S corporations must be U.S. citizens, and neither C corporations nor LLCs may be shareholders in an S corporation.

Pass-Through Taxation

S corporations are afforded favorable tax treatment when compared with C corporations, because taxes are paid at the individual employee or shareholder level, and corporate earnings are not taxed.

LLC Basics

The limited liability company (LLC) is another common business entity type, and is relatively newer than the corporate business entity form. State legislatures in all 50 states have enacted various versions of an LLC Act to create a legal form for businesses that includes much of the flexibility in structure and operation that was traditionally associated with corporations, as well as the favorable pass-through tax treatment provided to partnerships. 

LLCs can be arranged to operate in a similar fashion to corporations, but there are some significant differences. Here are some of the central features to consider if you are wondering whether to organize your business entity as an LLC:

Ownership

LLC owners are called “members” rather than shareholders. Members hold “membership interests” in the LLC, and these interests, similarly to corporate shares, can be divided into different classes with varying economic and voting rights. Members can agree to special rules regarding equity structure, but the default rule is that membership interests are expressed as a member’s percentage of the total ownership in the company. For example, if you are one of four owners of an LLC wherein all members have equal ownership, then each of you hold a 25% membership interest in the LLC.

Governing Documents

An LLC is formed by filing articles of organization with the State Corporation Commission. The LLC can also adopt an operating agreement to establish rules for how the company will be run.

Limited Liability

Like a corporation, an LLC provides limited liability to its members, so members generally cannot be held personally liable for the debts or other liabilities of the company.

Flexibility and Fewer Required Formalities

One reason many business owners decide to form an LLC rather than a corporation is that corporations are subject to numerous requirements relating to their boards of directors, meetings, notice of meetings, and other issues. LLCs can elect to follow these formal requirements, but do not have to by law. LLC operating agreements are also treated with significant deference by courts.

Pass-Through Taxation

Like S corporations, LLCs are afforded favorable tax treatment when compared with C corporations, because taxes are paid at the individual employee or shareholder level, and corporate earnings are not taxed.

How Do I Choose the Best Business Entity Type?

Now that we’ve covered some of the important similarities and differences between LLCs and C and S corporations, you might be wondering how to decide which option is best for your business. Here are some factors to consider to simplify your decision-making process:

Tax

If pass-through taxation is important to you, consider opting for an LLC or S corporation. However, please note that there are certain types of businesses, such as businesses holding real estate, for which S corporation status can lead to significant tax problems down the road. 

Flexibility

Corporations and LLCs are both fairly flexible business entities, but the level of deference given to an LLC’s operating agreement makes it a good choice for those who are seeking the maximum ability to organize their business’s operations as they see fit.

Raising Capital

It is possible to bring on investors with any of the entity types discussed in this post, but if your business is likely to seek or rely upon heavy early investment to grow, then the C corporation may be the best choice. This is because many seed stage and institutional investors such as angel investors and venture capital funds either strongly prefer or demand C corporation status.

Conclusion

There are numerous considerations to take into account when choosing whether to form a corporation or an LLC. Some of the most important factors to keep in mind are tax treatment, operational and organizational flexibility, limits on ownership, and whether you will seek to raise capital. In a future blog post, we will discuss how to proceed with forming your business once you have made a decision as to which legal form it will take.

If you have any questions about choosing and forming the best business entity form for your business, please feel free to contact our firm.