Does it make sense to set up an LLC or S-Corp for my startup?

QUESTION:

I would like to incorporate a value-added engineering software reseller business. It would be a Pennsylvania based company of about 15-25 employees working out of their home offices (no corporate office). The business involves sales representatives and technical employees delivering on-site training, demonstrations, and technical support.  Would it make more sense to set up an LLC or an S-Corp?

ANSWER:

Antone Johnson

Antone Johnson

by Antone Johnson at Bottom Line Law Group

The answer primarily depends on two factors: Will you need to raise any investment capital from professional sources, and do you expect to issue stock options or other equity to your employees? If the answer to either of these questions is yes, it makes sense to incorporate rather than to form an LLC.

If this is the type of business that’s expected to be cash flow positive early on, and you’ll be compensating employees primarily in cash with salaries, bonuses and/or commissions — which sounds like it may be the case with a reseller business — an LLC may be the way to go. Both LLCs and S corporations offer the benefit of being “pass-through entities” for tax purposes — whereas corporations are subject to double taxation. Consult a tax advisor for more information and personalized advice.

If you want or need to issue stock options, a corporation is the most sensible alternative. (LLCs have members and membership interest, as opposed to shareholders and shares.) Although it’s possible to issue the equivalent of stock options to employees of an LLC, it’s complicated and rarely done in practice. By contrast, a stock option plan for a corporation is a common, well-established method for offering equity compensation, particularly at technology companies, and offers favorable tax status (incentive stock options, or ISOs) to eligible employees.

Strictly speaking, a corporation is a corporation; subchapter S (versus a “C corporation”) is a tax status for which certain closely held businesses are eligible. You can start out as an S corporation and convert to C corporation tax status later if necessary. The rules around S corporations are fairly restrictive; there must be no more than 100 shareholders, all of them US citizens or residents, and all natural persons (no business entities or institutions). Most tech startups and other growth companies have no choice but to be a C corporation, to enable equity investment by venture capital or angel investors in the form of preferred stock. (LLCs and S corporations can’t issue preferred stock.)

NOTE: Consider using a filing service such as Legal Zoom where they file all the documents with the state, get your record book, and more.

Comments & Advice:
  1. Antone, thanks for your insight. Would you be able to explain further your thoughts behind why an LLC is preferable to an S-Corp for a business with early cash flows? Thanks!

    “If this is the type of business that’s expected to be cash flow positive early on, and you’ll be compensating employees primarily in cash with salaries, bonuses and/or commissions — which sounds like it may be the case with a reseller business — an LLC may be the way to go.”

  2. Steve says:

    If you are setting up an LLC in New York, be careful! Without the right guidance, you may spend way more than necessary due to New York’s legal publishing requirement for LLCs.

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