(last updated April 2021)
The primary rationale for conducting business through an entity like a corporation or limited liability company (LLC) is to protect the owners of the business from becoming personally liable for the debts of the business. In other words, normally, if you form one of these entities and fund it with $1,000, the most that you could lose is that $1,000 even if the entity becomes obligated to pay more than that because, for example, it is sued. There are circumstances where business owners need to voluntarily assume some personal liability, like a personal guarantee of a bank loan or real estate lease, but even in those cases, the potential personal liability is limited to those particular company debts, not all other debts of the company.
Additionally, if the business has more than one owner, forming an entity provides an established mechanism for dividing up among the owners the profits that the business hopes to have one day.
Your corporate attorney (hopefully me) can provide some advice on entity selection and structure, but entity choice is often driven by tax considerations, so you need to be consulting also with a qualified tax advisor – a tax attorney and/or accountant. Once the type of entity is selected, the corporate attorney (again, me) should coordinate the formation process including drafting of startup documents. Some accountants take this task upon themselves, but in my opinion that’s as advisable as it would be for me to do your tax returns.
Entities are formed by the filing with a state’s Secretary of State (or Department of State) of a usually short document that has different titles depending on the type of entity and the laws of the state in which it’s filed: Certificate of Incorporation, Certificate of Formation, Articles of Organization, etc. Each state has instructions for doing this yourself, like mailing it in with a check for the filing fee, but it’s advisable to use a corporate services company, who can coordinate the process for an additional service fee. It’s money well-spent, as DIY filings can, in my experience, get lost in the state office.
Most new businesses that I see in my general practice are corporations or LLCs. There are other types, like general partnerships and limited partnerships, which you are more likely to see nowadays in specialized settings, like fund structures. Within the category of corporations, there are C corporations and S corporations. The C or S corp distinction is purely a tax classification – state corporate law generally doesn’t distinguish between them – but the IRS rules applicable to S corps discussed below affect how they can operate. Each state also has its own special rules applicable to “professional” corporations and LLCs, meaning entities engaging in a licensed profession like law, medicine or engineering.
Although most of the largest businesses familiar to the public are organized as C corps, the type of entity does not inherently make the business more or less valuable. There are plenty of large and quite profitable LLCs. Amazon.com, Inc. is a Delaware C corp. I can form my own Delaware C corp today, but that doesn’t mean I’ll be in a position to start a rocket company anytime soon.
A corporation or LLC can be incorporated or organized in only one state, but if the company is doing business in other states, it must qualify to do business, known as foreign qualification, in those other states. The definition of “doing business” in another state is defined under those state’s individual laws. Some, like California, have an expansive definition, so be sure to speak with your attorney about your proposed activities in another state and don’t just rely on what you think “doing business” means to you.
A disproportionate number of entities are organized in Delaware, even if they otherwise have no connection to the state. Delaware has flexible, management-friendly corporate and LLC laws, and its courts are experienced at deciding business cases. The Secretary of State’s office there is very efficient at processing filings. However, particularly if you are a small business focused on costs, note that if you incorporate in Delaware and do business in another state, you’ll need to pay entity-related costs in at least two states.
Generally speaking, corporations require more formality than LLCs. The corporate statutes in each state require, for example, various actions to be approved by a board of directors and/or the shareholders and for board actions to be evidenced by a formal meeting or unanimous written consent of the full board. LLCs, in contrast, generally allow each company to decide how it is run by contract, through the company’s operating agreement.
Corporations require a specific management structure: the shareholders elect a board of directors, which, in turn, appoints officers to run the business day to day, with significant matters being approved by the board. For LLCs, in contrast, the operating agreement can establish a process that is as simple or complex as the members want; it can say that one person is the managing member and runs the show, full stop, with other members holding only passive economic interests, or it can establish a board of managers with formal requirements similar to that of a corporation, or various structures in between those two extremes.
Again, with respect to distributions of profits, LLCs are more flexible than corporations. For a corporation, each share of a particular class of stock must be treated equally for all holders. So, if a corporation has one class of shares with 100 shares issued and outstanding, and it is distributing $1,000 in total as a dividend, then each share will receive a distribution of $10, regardless of the breakdown of shares among its holders. There are situations where parties want to have an unequal division of profits, for example, when investors negotiate to get their investment paid back first before the founders of the company see anything. For a C corp, this is handled by creating a separate class of shares, say, Series A Preferred Stock, and then the company’s Certificate of Incorporation will state that the Series A Preferred shares will get their invested capital back before dividends can be paid on the Common Stock. The big drawback of S corps is that they cannot have multiple classes of stock, so this sort of arrangement does not work. LLCs are the most flexible of all: they can have multiple classes like C corps, but the operating agreement provisions can be even more informal by defining the rules for distributions however the parties agree, a provision known as the “distribution waterfall.”
Business taxation is complex and all of the details are beyond the scope of these FAQs, and, frankly, beyond the scope of my knowledge (again, you need to consult with a qualified tax professional in selecting an entity). However, the big picture from 30,000 feet is as follows:
- C corps have double taxation: the entity itself is taxed on its profits, and there is another, separate tax on its shareholders on the dividends paid out to them and gains when they sell their shares.
- LLCs have what’s known as “pass-through” taxation, unless they affirmatively elect to be taxed as a C corp or an S corp. This means that the entity itself doesn’t pay a tax, but instead the entity’s profits and losses are allocated to the individual members and taxed on their personal returns, with the method of allocation set forth in the operating agreement.
- S corps also have pass-through taxation, and can possibly pay less in self-employment taxes than an LLC. But S corps have other restrictions such as the inability to have multiple classes of stock, a limit of 100 shareholders and the inability to have other business entities be shareholders.
Just from a mechanical perspective, conversion is pretty straightforward. For C corp to S corp or vice versa, it’s a matter of filing an election with the IRS. For corporation to LLC or vice versa, it’s a matter of state law: it’s either a simple conversion, or the existing entity merges into a newly formed entity that is in the desired form. The important thing is to ensure that the conversion, however structured, does not trigger a tax which, again, requires the input of qualified tax personnel. It is common for startups to be organized as LLCs and then convert to C corps in anticipation of an investment by institutional investors like venture funds, which prefer to invest into C corps.