We get questions all the time about the C corp vs. LLC startup debate ALL THE TIME, but what really is the best answer for your startup? And why is the whole thing so important anyway?
Well, when starting a business, one of the first decisions you need to make is what type of entity to form. There are many different types of entities, but two of the most common are the C corporation (commonly called, the “C corp”) and the limited liability company, or LLC.
There are many misconceptions about C corps and LLCs: what they are, how complicated they are, and especially, the relative tax advantages and disadvantages of C corps and LLCs. In this blog post, we will compare and contrast the C corp and the LLC (and also discuss their cousin, the S corp) and help you decide which is right for your startup.
Why Does an LLC or C Corp Structure Matter to a Startup?
You may be wondering, “Why does it even matter whether I choose to form an LLC or a C Corp?”
The choice of entity for your business can have significant implications for how the business will be taxed and what kind of governance and management will be required. It’s also a significant factor in what kind of investors you can attract for startup funding.
For these reasons, it is important to choose the right entity for your startup from the outset.
What Is a C Corp? What Really Is the C Corporation Structure?
A c corporation is a legal entity exists entirely separately from its owners. Importantly, that means that a corp is its own entity for legal matters such as accounting, taxation and legal liability.
C Corp Benefits
The main advantage of choosing the c corporation business structure is that it shields its owners (the corporation shareholders) from legal liability.
Because the C corp is its own legal entity, that means that if the company is sued, the shareholders will not be held personally responsible for the debts of the company and their personal assets cannot be touched.
So for example, say you were the shareholder in General Motors (which is a C corporation) when it was sued for manufacturing vehicles with faulty ignition switches.
Even though the General Motors Corporation was sued for hundreds of millions of dollars, the actual corporation shareholders were shielded from personal liability by the corporate structure and they did not have to pay any settlements or the corporation’s debts out of their personal assets.
C Corps and Investors
One big advantage of the c corporation business structure is that it is much more attractive to investors than that of an LLC. In fact, many investors like venture capital firms and some angel investors will only invest in business entities structured as c corporations.
This is for a few reasons, but one of the most important is because of the tax implications of the business structure.
Because c corporations are treated as having a tax status as a “person” separate from their shareholders for federal income tax purposes, investors only pay taxes when the c corp distributes corporate profits to them.
What’s the alternative? In pass-through tax entities (like limited liability companies), the profits and losses of the entity “pass-through” and are reported on the owners personal income taxes whether there has been a distribution or not.
In some cases, it may be more advantageous to have these profits and losses “pass-though” to an owner’s tax returns. For example, if there have been tax deductible business expenses, the owners may want to use them to offset other income on their personal income tax.
However, many investors do not want to be managing the tax consequences of this kind of “pass through” on their own personal tax returns and the impact those profits and losses may have on their personal income tax rate, maximum personal tax rate, and other complex tax rules.
C Corporations and Preferred Stock
C corporations can also offer investors preferred stock, which gives them certain rights and privileges that are not available to the owners of an LLC. C corporations can offer investors multiple series and classes of stock with different rights attaching to each, which makes it a structure suited to multiple rounds of investment and financing.
Employee Incentive Programs (Stock Options and Ownership)
A C corporation can also offer employees incentive programs such as stock options and stock ownership, which is really not possible with something like an LLC. This can be a very important way to attract and retain top talent, especially in tech-heavy industries.
Disadvantages of the C Corporation Structure
However, before you run out to form a C corporation, there are some significant disadvantages you should be aware of:
C Corporation Disadvantages: Double Taxation
One major disadvantage of the C corporation business structure is that it is subject to “double taxation”.
This means that the business will pay corporate income tax once on the corporation’s earnings, and then the owners will also pay the taxes on the shareholder dividends they receive from the company on the owners tax returns. While this tax structure can be a benefit for investors who don’t want to deal with managing the profits and losses of their various investments regularly, if you’re a small business owner, double taxation is a major disadvantage of forming a C corp.
C Corps and Management
Another disadvantage of a c corporation is that it requires more management than an LLC.
Forming a C corporation requires a corporate governance structure, including filing an articles of incorporation and setting up a board of directors. Director meetings and a registered agent for service are also required.
Depending on state corporation laws, C corps may also be required to file annual reports, maintain corporate records and stock certificates, and pay state filing fees.
Because of these legal requirements, choosing the C corp business structure can be an expensive and cumbersome proposition, especially for small businesses.
What Is an LLC? What is the LLC Structure?
An LLC is another type of business structure that also offers limited liability protection to its owners. An LLC also has some tax advantages over a C corporation. For example, an LLC can choose to be taxed as a “pass-through” entity (and most do), which means that the LLC will not be subject to double taxation.
Advantages of the LLC Structure
As mentioned above, one major advantage of an LLC is that it offers limited liability protection to its owners. So like with a C corp, if the company is sued, the owners will not be held personally liable for the debts of the company.
Flexibility and Management
However, unlike with C corporations, the LLC is a much more flexible business structure and much easier to manage which makes it ideal for many small businesses and small business owners.
Unlike with C corporations, LLCs do not require filing articles of incorporation or setting up a board of directors. Depending on the state, filing annual reports may not be required either. In many states, all that may be required may be a one-page filing and the designation of a registered agent, making an LLC a relatively inexpensive and easy way for business owners to shield themselves from personal liability.
In fact, in many states, setting up an LLC may be simple enough for most small business owners to set-up on their own through an online legal service such as LegalZoom, ZenBusiness, or IncAuthority.
Also, LLCs are generally treated as “pass-through” entities for income tax purposes. Unlike with C corporations, where the company pays taxes on its earnings at the corporate level, and then the corporation shareholders pay taxes again when they receive dividends, an LLC’s profits and losses “pass-through” to its owners.
That means that those profits are only taxed once, with the owners’ personal tax returns, and if there are losses, they can be be used to offset other income. Although some investors prefer waiting to pay taxes when dividends are distributed (as with C corporations), for many business owners, paying taxes only once is a major benefit of LLCs. For this reason, LLCs are a very common business structure in some industries such as real estate development.
Disadvantages of the LLC Structure
LLCs and Investors
The major disadvantage of an LLC is that it may have difficulty attracting investors. Because of its tax status as a “pass-through” entity, many investors (like venture capital firms) avoid investing in LLCs because it complicates their taxes.
LLCs and Management
In addition, although more flexible than C corporations, LLCs do require some management (usually set-up in operating agreement), and, depending on the state you are in, may be subject to paying annual fees and filing annual reports.
Other Business Structures to Consider
C corporations and LLCs are not the only business structures out there. If you are starting a new business, you may also consider the following business structures:
A sole proprietorship is a business owned by one person. This is the simplest business structure possible, with no extra filings or additional layers of tax. However, there is also no shield from personal liability, and the owner of the business is personally liable for the debts of the business.
A partnership is a business owned by two or more people. As with a sole proprietorship, there are no required filings or double taxation, but again there is no shield from personal liability and the partners are personally liable for the debts of the business.
Benefit corporations are a type of corporation that have a general benefit purpose stated in its articles of incorporation. That means that benefit corporations are still subject to the common corporation requirements (articles of incorporation, a board of directors, shareholder meetings, etc.), but a benefit corporation pursues that public benefit purpose in addition to profits. Because that public benefit purpose may sometimes come at the cost of corporate profits, that’s something that’s not always popular with investors.
What About S Corporations?
Some of you may be asking, “Well, what about S corporations?” S corporations (or “S corps”) are actually not a separate business structure like an LLC or C corporation. Instead, “S corporation” is actually a tax designation which allows the S corp to be taxed in a specific way.
So an S corporation is a corporation (like a C corporation), but it elects to be treated as a “pass-through” entity (like an LLC) by the Internal Revenue Service. That means that like other corporations, an S corporation must file articles of incorporation and establish a board of directors, but unlike C corps, are not taxed at both at the corporate level and at the owners’ level.
Instead, like an LLC, an S corporation’s profits and losses pass-through the S corp to be taxed at the level of the S corp shareholders.
S corp shareholders can also be employees of the S corp which may be a consideration for some owners as well.
This Sounds Great! Why Not Just Become an S Corporation?
Not so fast. Even though S corp designation can sound awfully appealing, there are some very specific restrictions around S corps.
S Corps and Shareholders
The major drawback of S corps and the reason more founders do not choose the S corporation election is because of its strict restrictions around shareholders.
S corps are allowed to have no more than 100 shareholders which means the S corp is not an option for any companies that are considering going public.
S corps are also restricted in who can be a shareholder. S corp ownership is restricted to U.S citizens, permanent residents, estates, and certain domestic trusts and organizations. Most importantly, other corporations and partnerships are not allowed ownership in an S corp, which means it is not an option if you plan to raise money from any institutional investors.
So… C Corp vs. LLC Startup Debate: Which Is Right for My Startup?
The answer to this question depends on a number of factors, including the type of business you are starting, the amount of money you are seeking to raise (if any), and your long-term goals for the company.
If you are starting a business that will be seeking equity financing from a venture capital firm or other investors, then a C corporation will likely be the better choice. C corps are the preferred structured for most investors, and they are better suited to the complex issues involved in multiple rounds of equity financing.
If you are starting a business that does not intend to seek investment from venture capitalists or similar investors, then an LLC may be the better choice. This is because an LLC offers flexibility in terms of taxation and does not require the same level of management as a C corporation.
Does Forming a C Corp or LLC Have to Cost a Lot of Money?
Not necessarily. Of course, if your situation is more complicated, for example if you have co-founders, investors, and/or employees expecting equity or some kind, you should consider consulting an experienced business attorney.
But if your situation is not complicated, you may be able to form your C corp, LLC, or S corporation on your own through an online legal service such as LegalZoom, ZenBusiness, Northwest Registered Agent, or IncAuthority which are much cheaper than paying lawyers’ fees.
Online legal companies like these can provide inexpensive and timely services that can help you set-up your company’s legal entity, maintain filing compliance with filing rules and regulations, and file for an employer identification number (EIN)
But no matter what your situation, if you have any questions at all, it is important to consult with an experienced business attorney to ensure that you are making the best choices for your business.
Are you thinking of raising venture capital? Read more about How to Raise Venture Capital, How to Create a Startup Pitch, How to Create a Venture Capital Pitch Deck, Venture Capital Advantages and Disadvantages, and 15 Pre-Seed Venture Capital Firms who Invest in Early Stage Startups.