Which entity is best for a start-up?
First, let’s define each type of entity and how they can be formed. Then we will discuss which is best.
An LLC (Limited Liability Company) is a hybrid of a partnership and Corporation. Instead of “Shareholders”, owners are referred to as “Members”. In a corporation there are officers that run the company, such as President, Treasurer, Secretary. With an LLC there are no officers, instead they are referred to as “Managers”.
An LLC also has different documentation than a Corporation. Instead of Articles of Incorporation, an LLC has Articles of Organization. Instead of Stock Certificates in a Corporation, the LLC has Membership Certificates.
LLC’s are not required to have annual meetings and keep resolutions according to state statutes, whereas Corporations are. However, it is advised to maintain meetings and documentation for an LLC for tax purposes.
Here is where the question of “Which entity is best for a start-up?” because a little tricky to answer. On the IRS form “SS-4” to obtain a Tax Identification Number for the company, it asks for “Type of Entity”. For an LLC you could choose “Sole Proprietor”, “Partnership” or “Corporation”. The default status if none are selected, is “Partnership”. In most cases this is the election that most companies select.
When choosing Partnership, the company now is taxed the same way as the S Corporation or a Partnership. Which means, the S Corporation and LLC have very similar features and benefits.
As mentioned above, there are differences between the LLC and S Corp in regards to the terms and paperwork. There are additional differences as well.
With an S Corporation, there are limitations on who can become a shareholder. For example, an S Corporation may not have more than 100 shareholders, and they must be U.S. citizens or permanent residents.
The LLC on the other hand does allow foreign citizens to be members, and there are no limitations on the number of members either. If an investor wanted to buy into the business and use their own Corporation or LLC, only the LLC would allow another entity to have membership units in the LLC.
Another difference, in an LLC income and loss can be allocated disproportionately among the owners. Whereas, the S Corporation has to assign income and loss to each shareholder based on their pro-rata shares of ownership.
If you plan to bring in investors or other shareholders and want to create different classifications of stock, the S Corporation will not allow different classifications but will permit non-voting and voting shares. The LLC does allow for various membership classes.
VC Funding? If you are looking for VC Funding, most VC firms will only invest in a C Corporation. This does not mean you have to start as a C Corporation. You can convert an S Corporation back to a C Corporation in most cases, and if this is something you are considering the S Corporation would be easiest to convert.
If you’re looking for information about the differences between an LLC and C Corp, here is a good article.
When forming a corporation or LLC, consider using a filing service such as Legal Zoom where they will file all the documents with the state, get your record book and more. However, if you are looking for complicated agreements with investors and other shareholders, you should seek legal advice on drafting that agreement. The paperwork to file the corporation or LLC can be done by an attorney as well, but why spend the extra money for the filing? Save the money and use it for the agreement with shareholders, which is the most important piece anyway. The agreement is referred to as the Bylaws with the Corporation and an Operating agreement with the LLC.