LLCs vs C Corps

What you need to know before you form your company.

Limited liability companies (LLCs) and C Corporations are the two primary corporate entities in the United States. Each entity type has some features which are more advantageous for some businesses than for others.

We’ve collected some information here so that you can make an informed choice, in consultation with your professional advisors.

Our legal preferred partners and advisors have contributed their expertise to this section (see disclaimer at the end of this document for information about this guide.)

 

LLCs

An LLC is a type of company organized under an Operating Agreement, which is a contract between the owners (called “members”) specifying how it will be run and how the economic burdens and returns will be split between the partners.

The possibilities for how to structure an LLC are almost endless, which can be a blessing and a curse. This makes interfacing with an LLC challenging, because one has to examine the Operating Agreement (and potentially other contracts signed between the members) to get a handle on how the company is governed. C Corporations, by comparison, are more standardized: they share commonalities like stock to represent ownership, governance by a board of directors, day-to-day operations handled by officers, etc.

There are a few characteristics that are common to LLCs:

  • LLCs are intended to provide limited liability for founders; moving liability for debts and obligations of the business from the entrepreneurs into the company itself.
  • LLCs offer pass-through taxation, the LLC’s owners generally pay personal income taxes on the income of the business

C Corporations

A C corporation is an entity designed to act as an abstraction layer between the operators of the business and the owners of the business, who may or may not be operationally involved. Ownership is tracked by shares, with each share corresponding to a defined portion of control of the business and entitlement to the economic upside of it. Owners are called shareholders.

Many companies which are household names are C corporations; one can own shares at Google without having any responsibility for working there. This assumption that control and ownership may be separate flows through the mechanics and regulation of C corporations. The state of Delaware has a highly developed body of law governing corporations which can lead to a high degree of predictability in the event of a legal dispute.

There are a few characteristics common to C corporations:

  • C corporations are intended to provide limited liability; shareholders are generally not individually liable for the debts and obligations of the company.
  • C corporations are assessed corporate taxes on their own profits (and have extensive filing obligations). Shareholders are taxed separately, if the company distributes dividends to them (or if it pays them a salary, in the case of employee owners).

Standard features of companies

Both LLCs and C corporations are companies. In the United States, third parties such as the government and companies you may wish to do business with are generally happy to deal with both types of company; this is not true in some countries (where the local equivalents of LLCs may be at commercial disadvantage relative to local equivalents of C corporations).

Both LLCs and C corporations are intended to limit the liability of owners and officers for the acts of the company and for debts which the company may have.

Both LLCs and C corporations can be parties to contracts, can own other companies (and be owned by them in turn) or virtually any other asset, can get banking services, and can generally operate businesses.

Assets and IP

LLCs are chosen by many founders of side projects, small teams, bootstrapped businesses, or businesses which don’t know what they want to be when they grow up yet. (They can also scale to support businesses of almost any size. Basecamp is an LLC, for example. Facebook started as an LLC, and converted to a C corporation later.)

One reason why LLCs can be well-suited for side projects is because money and IP can flow relatively freely between the members of an LLC and the LLC itself, often without the tax consequences that would result if the transactions happened in a C corporation, and often with a minimum of ceremony.

This is conceptually possible with a C corporation, but it involves more record keeping and (potentially) thorny tax considerations, particularly with regard to, e.g., intellectual property. Most major actions of a C corporation also require some ceremony, such as formal resolutions of the company or votes of the stockholders; LLC Operating Agreements often empower the owners and/or managers to simply act.

Taxation

LLCs are considered pass-through entities for the purpose of US taxation; they don’t file taxes in their own right, but have their income reported on the personal income tax returns of their owners. C corporations file their own tax returns. (Somewhat confusingly, C corporations can sometimes elect pass-through status, and LLCs can elect to be taxed like a corporation, but these are not their default treatments.)

Money flowing through an LLC is taxed at the level of the owners of the LLC; money flowing through a corporation is taxed at both the corporate level and, additionally, when it passes to the owners (either as salary or as a distribution of profits).

The different tax treatment of these entities can have interesting implications, particularly if the company is making losses, as many companies do early in their lives. A C corporation which makes a loss in any given year generally carries the loss against future tax years, where it can be used to offset future profits. A loss earned by an LLC may generally be used to offset income of the owners during the same tax year, for example, income from employment.

Consider the case where a company spends $10,000 in its first year in operation and has no revenue. A C corporation would likely have to defer that $10,000 loss to a future year to gain any tax benefit. An LLC might be allowed to reduce its owner’s total income by $10,000; this could result in decreasing the owner’s income tax bill by several thousand dollars. For someone working in technology in the US, this could result in them getting a substantial refund, which they could use to fund the business’ growth or for any other purpose—it’s their money.

International Owners

Neither the United States nor the state of Delaware currently imposes a citizenship or residency requirement on the owners of LLCs or C corporations. That said, owning an LLC can expose non-resident or non-citizen owners to very complicated tax situations. Non-resident US citizens may be obligated to file US taxes on the income that their LLCs earn, and also have to consider how that income will be taxed in their local jurisdiction.

For example: consider an LLC with two owners, one in the United States and one non-US citizen in Japan. The owner in Japan will likely be taxed on their income from the LLC by the United States. The owner in Japan may also be taxed in Japan on the same income. This substantially increases the complexity of their tax reporting.

Investment

Professional investors overwhelmingly prefer investing in C corporations versus investing in LLCs.

From the various legal guides: [M]any types of investors will not be interested in (or may be legally barred from) investing in LLCs because of the income and loss pass-through nature.

The extreme flexibility available in the LLC form also means that investors attempting to invest in one will have to do substantial legal due diligence to ensure that they are buying what they expect to be buying. Many investors do not want to do substantial expensive legal work as a condition of making an investment; they prefer to make investments in standardized companies under standardized terms. C corporations are much better suited to this preference.

In the event that one receives an offer of investment as an LLC, one may be requested by many investors (including, e.g., YC) to convert to a Delaware C corporation as a requirement of taking the investment before the investment is made.

Employee Ownership

Both LLCs and C corporations can have employees. While in principle it is possible to give an employee ownership but not control over an LLC, this is non-trivial. C corporations have well-understood mechanics to issue employees equity or options for equity, with well-understood tax consequences, and cultural and infrastructural support for this form of ownership throughout the tech industry.

Employees and advisors are likely much more comfortable with receiving equity than they are becoming members in an LLC, which could complicate their own tax situations for the length of the LLC’s life (even if, e.g., they leave the employment of the LLC).

Vesting

Vesting is a mechanism by which founders or employees of a company earn their ownership over time.

While corporations have a clean way to distinguish partners in the enterprise from owners, these concepts are intrinsically commingled in LLCs. An owner departing an LLC may require a negotiation between the departing partner and remaining partners regarding the terms of the separation. Some companies will want this to be a clean break, potentially with the remaining parties buying out the departing partner’s interest. Some may want to continue paying the departing partner a portion of the profits. These decisions are complicated and often depend on companies’ situations and the desires of their owners.

Norms for vesting are also not as established in LLCs as they are in C corporations in the tech industry; many LLCs are formed between family members (where relationship considerations may trump contractual arrangements), departures which do not result in the partnership dissolving are rarer, and ownership without control would not be as valuable as it frequently becomes in C corporations, which often contemplate operating at materially larger scale.

Converting an LLC into a C Corporation

LLCs can generally be converted into C corporations. (In principle, C corporations can convert into LLCs, but this is rarely done.)

Because LLCs are governed by contractual arrangements between the members, derisking the conversion process for an LLC generally requires extensive legal review, which increases the monetary and time costs of converting.

It is important to have your Operating Agreements written to anticipate a possible conversion. There is a defined process to start a conversion. The ownership is tracked in units which can map to issuance of shares in a future C corporation and the OA should allow the users can customize for conversion.

Where is the LLC formed?

Each state of the United States can form LLCs and C corporations, irrespective of where the founders live or where the actual operations of the company take place. Each state attempts to create a product offering for their LLCs / C corporations which makes them attractive, for the purpose of attracting fees and economic development locally.

It must be reminded that if the LLC or Corporation is formed in the state of Delaware, you will be required to register as a “foreign” LLC in the owners’ state(s) of residence or operation. Let’s say you are operating in Illinois, then you have to also register your business there. This is typically a straightforward process requiring a modest fee per year. Regulations for founders living outside the US vary widely; please consult a local accountant or attorney or your local government.

 

In case you are still thinking of forming and LLC, here is what you need to be aware of:

LLCs in some cases can be customized for the needs of technology founders by creating more defined Operating Agreements.

You should read the entire Operating Agreement before you sign it, because it is a legal contract, but here is some information about its terms:

  • The LLC is organized under the laws of Delaware.
  • The LLC is managed by the managers, allowing day-to-day decision and management responsibility to be distinct from ownership (being a member). The company can have non-owner managers or owners who do not have management responsibilities.
  • The LLC contains an IP assignment in its Operating Agreement assigning relevant IP that has already been created and is held by the members to the LLC at the time the LLC is formed.
  • Ownership in the LLC is tracked via X0,000,000 units, which function similarly to shares, and which represent a simple ownership stake of the company with only a single class of owner.
  • The LLC supports adding new owners (via unanimous consent of existing owners).
  • The LLC supports removing owners (via unanimous consent of all owners).
  • The LLC includes language to simplify the process of conversion to a Delaware C corporation.
  • The LLC include vesting of ownership.

 

And finally, a summary:

The short answer is that for big companies, Delaware offers numerous advantages. However, the average small business may never notice any of these benefits; in fact, incorporating in Delaware can add cost and complexity.

In other words, the decision to incorporate in Delaware isn’t the same for every business. Following are the key benefits and drawbacks associated with incorporating in Delaware to help you better understand what’s right for your company.

Incorporating in Delaware holds some advantages; here are the key ones:

The Delaware court system is well established and highly respected. Delaware’s Court of Chancery specializes in corporate issues and uses judges instead of juries. But the business legal system has improved and almost all states have now laws in place that are as good as or better than Delaware.

Delaware offers a lot of flexibility for structuring your corporation. Delaware’s corporate statutes are very flexible in terms of how you can structure your corporation and board members. For example, shareholders, directors and officers don’t need to be residents of Delaware. Delaware allows just one person to be the only director, shareholder and officer of a corporation. In other states, you may need a minimum of three people to hold the officer and director positions.  But it is not the case in Illinois.

Delaware offers greater privacy. Delaware corporations don’t need to disclose officer or director names on the formation documents. This gives you a layer of privacy (if needed, or if you are hiding from something!).

Investors sometimes prefer Delaware corporations. Large VC investors and investment banks typically prefer Delaware corporations above all other states and business structures. If you are looking for C or D series VC funding or going public (IPO, Delaware could have some advantages, instead of having to convert your company when that’s demanded by an investment banker or venture capitalist.

Delaware offers some tax advantages. While states like Wyoming and Nevada are rising in popularity due to their lack of state corporate income tax, Delaware has some business-friendly tax law. Businesses that are formed in Delaware but don’t conduct business there do not need to pay state corporate income tax (though there is a franchise tax). Also, stock shares owned by people outside Delaware aren’t subject to Delaware taxes. However, many states that are open to startups have great tax incentive packages in place that eliminates the need for Delaware.

The drawbacks of incorporating in Delaware

From the list above, you may be impressed with how seemingly advantageous Delaware is for corporations. And certainly, if yours is a large corporation with thousands of shareholders and hundreds of millions of dollars in revenue, you will see benefits from incorporating in Delaware. However, these same benefits may not mean much for a smaller business.

In fact, the drawbacks may tip the scale against incorporating in Delaware.

The main drawbacks occur when you incorporate in Delaware but aren’t actually headquartered or doing business there. Let’s say you’re physically located in California or Illinois, but choose to incorporate in Delaware. In this case, you’ll need to pay the annual franchise tax in both states. You will also need to follow the reporting requirements for both states.

If the benefits of incorporating in Delaware don’t mean much to your company, then there’s no reason to tack on the added expense and administrative time for incorporating in Delaware if you’re not doing business there.

Whether you want to form a C Corporation or an LLC, Startup Port can help you get started. Learn more.

Legal disclaimer:

This guide is not intended to and does not constitute legal or tax advice, recommendations, mediation or counseling under any circumstance. This guide and your use thereof does not create an attorney-client relationship with Startup Port or any of its advisors and affiliates.  The guide solely represents the thoughts of various authors on the subject matter with expertise in their fields, and is neither endorsed by nor does it necessarily reflects Startup Port’s belief. Startup Port does not warrant or guarantee the accurateness, completeness, adequacy or currency of the information in the guide. You should seek the advice of a competent professional attorney, a registered financial advisor, a certified public accountant licensed to practice in your jurisdiction for advice on your particular problem.

 

Copyright 2008-2019 Startup Port and its affiliates. All rights reserved. Please read legal disclosure.