Business Structures: LLC vs. C Corporation

Deciding whether a company should be an LLC, a C corporation, or an S corporation is a big decision in the life of a company. Choosing your corporate form will influence how you are able to raise capital, your tax regime, corporate governance structure, and other responsibilities that you will have to manage going forward. Although some companies find that the LLC is a good intermediate form for them, most companies find that skipping the LLC stage and starting out as a C corporation makes better sense. There is no one best choice; each company must make the decision based on their individual needs and, importantly, how they will fund and grow their business.

You may want to form your company as a Limited Liability Company (LLC) because your company is small, you are not looking for institutional investment anytime soon, and the tax advantages of an LLC make sense for your company. Two friends and a dog in a garage creating an app is a classic example of a company that could be a good fit for the LLC corporate form. In this example scenario there are few employees, and since the company can create revenue with very little overhead, outside investment may not be needed. Despite the lure of the tax efficiency, companies that are looking for institutional investment or looking to incentivize their employees with equity usually find the C Corporation advantages outweigh its tax burdens (more on this in the next section).

An LLC’s main attraction is that it provides “pass through tax treatment.” In other words, the LLC itself does not pay income taxes. An LLC is a business ownership structure that allows owners to pay business taxes on their individual income tax returns. This allows the owners to deduct the losses from their taxable income. Another advantage of an LLC is that it does not require the same regulations and governance chores that a corporation has, like holding board meetings. It is important to take into consideration, however, that investors rarely invest directly in LLCs, and many, in fact, are prohibited from doing so.

When people use the term corporation, they’re usually referring to a C corporation. If companies do not choose this option at first, they will often find themselves converting their LLC into a C corporation later on down the road.

The C corporation structure is preferred and often required by institutional investors like venture capital funds for a number of reasons. A C corporation uses stock whereas an LLC uses units. LLC units require tax filing obligations that are not as well understood and are often times more burdensome to administer. C corporations can also accommodate many owners by allowing different classes and series of stock. For example, common stock can be issued to founders, management, and employees, while preferred stock can be sold with the desired rights, preferences, and privileges to investors. The ability to differentiate amongst classes and series of equity in such a familiar way makes it easier to attract a wide array of investors.

A C corporation does come with some disadvantages relative to other entities. From a tax perspective, the profit of a C corporation is taxed to the corporation when earned, and then is taxed to the stockholders when distributed as dividends. This creates a double tax. Further, the corporation does not get a tax deduction when it distributes dividends to stockholders. Stockholders cannot deduct any loss of the corporation. The C corporation is also highly regulated, and even a one or two-person C corporation must issue stock, elect officers, hold regular meetings for of the board of directors and stockholders, keep corporate minutes of all meetings, and follow the mandatory rules found in your particular state’s corporation code.

Many companies find that an S corporation is not right for them because 1) it does not permit more than 100 stockholders, and all of these stockholders must be people (as in natural persons, which excludes most businesses, but can include some trusts), 2) stockholders must be U.S. citizens or U.S. residents, and 3) it can only have one class of stock. However, if these factors are not a deterrent, an S corporation can be advantageous because it has pass through tax treatment similar to an LLC.

The main criteria in choosing an LLC or a C corporation is keeping in mind who will own the business, and what, if any, profits are expected early on. The C corporation is better suited for capital intensive businesses with lots of equity owners. The corporate form decision is a weighty one, but many technology companies that expect to raise venture capital find that a C corporation serves them best. Although it should be noted that while converting an LLC to a C corporation in Delaware requires additional paperwork and some small expenses, it is relatively straight-forward and can be done quickly (often times in connection with your initial institutional investment round).

Did you know that Fidelity can help your company incorporate as a C Corp in Delaware?