When starting a new business, choosing what entity to form is an important decision and can have implications for how you can raise money in the future, how you’re taxed, how you can bring on help, etc. Here are some things to consider when choosing whether to form an LLC or a corporation.
Corporations are required to follow certain formalities such as
- Have a Board of Directors which meets regularly (can be a single member under most state laws)
- Hold annual shareholder meetings
- Take meeting minutes
- Provide written advance notice to Board members and shareholders of meetings, including agendas
- Have officers, including at least a President, Secretary and Treasurer (multiple offices can usually be held by a single person)
LLCs are generally not required to have the same level of formality.
LLCs can be structured very flexibly. For example, company losses can be allocated to one class of investors and profits can be allocated to another class. Different classes of investors can be given very specific governance rights. Corporations are a bit less flexible.
In LLCs, it’s possible to provide a “profits interest” to investors – this kind of interest can be given for low or no cost to the investor in exchange for future services. It entitles the investor to share in future profits. There is no comparable option in a corporation.
With a corporation, the general rule is that when a worker receives an ownership interest in a business in exchange for “sweat equity” instead of paying the actual value of the interest in cash, the worker will owe income tax on the value of the interest received. This means the worker will have a tax bill and no cash to pay it with. This is why corporations often grant stock options to their employees. The options provide the right to buy stock at a pre-set price at some time in the future. Generally, an option grant does not create a taxable event for the worker at the time it is granted. There is a taxable event when the option is exercised and the shares are sold at a higher price. Options only make sense in a company that will eventually have a market for its shares.
The flexibility of LLCs can be a double-edged sword. While flexibility can be attractive, operating an LLC can be more complicated and expensive because there are so few default rules that LLCs must comply with. It is also easier to make costly mistakes making the advice of an accountant with a high level of expertise in LLC accounting essential.
When an LLC provides equity to employees, the employees are thereby converted to partners and are no longer technically employees. They cannot be given tax-advantaged fringe benefits and may not be covered by employment law requirements such as minimum wage, the requirement to buy workers compensation insurance, etc. In a corporation, when employees are given equity, they continue to be treated as employees for all purposes.
Corporations can be taxed under Subchapter S or Subchapter C. LLCs can elect to be taxed under those subchapters as well but are most often taxed under Subchapter K (this is the subchapter that governs partnerships).
Both Subchapter S and Subchapter K provide for pass-through tax treatment. This means that all items of profit and loss are passed through to the individual tax returns of the company owners. The entity itself does not pay federal income tax on its profits (although some states do impose tax on pass-through entities).
There are several differences between these two subchapters:
- An entity may only elect to be taxed under Subchapter S if it meets certain requirements:
- Fewer than 100 shareholders
- Only one class of stock
- All shareholders must be individuals and not entities
- All shareholders must be legal U.S. residents.
These requirements do not apply to taxation under Subchapter K. However, corporations may not elect to be taxed under Subchapter K. Subchapter K may only be used by LLCs and partnerships.
- Under Subchapter K, all revenues received by equity investors that work in the business are subject to both income tax and self-employment tax, regardless of whether you call it a salary, profit distribution, etc. Under Subchapter S, it is possible for the equity owners to take a portion of their earnings in the form of profit distributions which are not subject to self-employment tax. Because of this, in businesses where the owners take large salaries/distributions, Subchapter K can result in a much higher tax burden than Subchapter S.
For entities taxed under either Subchapter S or Subchapter K, at the end of each tax year, the accountant needs to allocate the entity’s profit or loss to the company owners. Each owner receives a form called a K-1 that instructs the owner what needs to be reported on his or her individual tax return. Many owners do not like having to deal with K-1s because it makes the preparation of their individual tax returns more complicated and they often do not receive the K-1 until late in the tax season.
Another concern with pass-through taxation is that it is possible that an owner could be required to pay tax on profits that he or she does not actually receive in cash. This is a problem called “phantom income.” This happens when an entity makes a profit but does not pay the entire profit out to investors in the form of cash distributions. This is a very common occurrence since most entities need to retain some amount of cash to cover short-term needs. The entire company profit is allocated to the investors regardless of how much cash they receive. Often, investors agree in advance that a minimum distribution will be made to at least cover the tax bills they have to pay because of their investment in the company.
Taxation under Subchapter C is standard for larger corporations. Unlike with the other two subchapters, entities taxed under Subchapter C do pay tax – items of profit and loss are not passed through to the equity investors. Federal corporate tax rates range from 15% to 35%. If an entity taxed under Subchapter C pays a profit distribution to an investor, the investor pays tax on that distribution. These are often subject to a lower tax rate than the standard individual income tax rate. However, these funds are technically taxed twice because they are taxed at the entity level and at the individual investor level. This is known as the “double tax.”
Considerations for companies that want to bring in outside investors
Many equity investors prefer to invest in non-pass-through entities because they do not like having to deal with the possibility of phantom income, K-1s, and other complications that can come with pass-through treatment. On the other hand, there are some investors that may have investments that generate passive income who are looking for an investment that will generate losses that can offset those gains on their tax returns. For investors to be able to take advantage of these losses, the entity must be taxed as a pass-through. Knowing what type of entity/taxation your most likely investors prefer is very helpful in making the choice of entity decision.
An LLC is preferable from the perspective of asset protection for the owners of the entity. If the owner of stock in a corporation is successfully sued, the creditor could be awarded the stock and gain control of the corporation. However, a creditor of an owner of an interest in an LLC cannot gain control of the LLC. The creditor is limited to a charging order which only allows the creditor to cash distributions made by the company. The creditor cannot force a distribution or demand any portion of the assets of the company and has no voting rights. This problem with corporations can potentially be addressed through the use of a Buy-Sell Agreement that provides for what happens if a major shareholder transfers his or her stock voluntarily or involuntarily.
Conversion from one to the other
From a tax perspective, it is generally easier to covert from a pass-through entity to an entity taxed under Subchapter C than vice versa.
Disclaimer: This post does not constitute legal advice! Please consult your tax advisor and/or attorney before making a final decision regarding entity type and taxation.