Colonel Sandurz – “Once we kidnap the princess, we can force her father, King Roland, to give us the combination to the air shield, thereby destroying Planet Druidia and saving Planet Spaceballs.”
Dark Helmut (to the camera) – “Everybody got that?”
One of the first questions I ask at the start of a new client relationship is about the current corporate form and how it was selected. I am never surprised about some of the complex answers to this simple question, usually involving a combination of results from internet surfing, peer advice and some heresay – reminiscent to me of this great scene from Spaceballs.
So, if you are looking for a detailed legal/tax analysis of the differences between these two forms of organization, you can stop here. These are just some practical pointers that I am passing along having dealt with this subject countless times.
Why an LLC?
This form is a great option for startups if you want to have the legal protection of a corporation, but a single level of tax. The S corporation is another alternative but it has limitations that lead to the creation of the LLC which is much more flexible. An LLC is the most common form of startup I see today. So, some LLC pluses:
– One level of tax – (Partners – called members – pick up their share of income and losses on their personal income tax returns and there is no tax at the LLC level). Owners who invest may be able to use losses to offset other income, so, it tends to work well for those who consult and use the money they earn to start their business. This is particularly helpful in, what I call, the Ramen Noodle phase of your company
– Flexibility – Participation in profit losses or capital gains can be different (disproportionate) for each member
– Similar legal protection as any corporation
– Corporations and other entities can be members
Why a C corporation?
This is the traditional form of business practice in the United States. It is well-recognized and lawyers are more comfortable using it. Regulations are relatively well-established and case law is robust to deal with the issues that arise. To me, there are really three common reasons you form a C corporation:
– Investors – An LLC can be an administrative nightmare for an investor. So, if a fund has 50 or 75 investors, at the end of a year, when that fund is informed of its share of your income or losses (reported on the famed K 1), they have to figure out the amount to report to each one of these investors. And, heaven forbid, there is some income and no cash (sometimes called phantom income.) So, virtually all investors request that companies convert to a C corporation as a condition of their investment. With a C, there is no annual tax reporting to investors required
– Incentive plans – The structure for incentives, such as stock options, restricted stock, etc. are well known in a C environment so this structure is conducive to providing those benefits
– Potential tax savings – Qualified Small Business Stock is a relatively recent provision in the tax code which provides incentives for smaller companies. Generally speaking, there are tax exemptions for certain gains from the sale of stock in a qualified corporation which is held for more than 5 years. It only applies to C corporations and it has given me pause to suggest staying as an LLC for too long a period of time
One final note on tax losses. Certain LLC losses are deductible on the tax returns of members but only to the extent of your basis – the amount you have ” invested ” in the business. So, if you are starting up, your parents lend money to your LLC and you use it for certain early stage type expenses, you cannot get the deduction
(and if it is a loan, they cannot either). One now has to weigh the benefit of this form versus moving into a C corporation where those losses are only available for future corporate income but, you can start the timeframe rolling for the QSBS exemption.
So, just some practical pointers on this subject. However, I would suggest consulting an advisor before you decide what form to use now and in the future as your business grows.