As promised, here is the follow-up question submitted by Jon who is debating the merits of selecting an LLC or a C-Corporation or an S-Corporation, as well as wondering where to setup such an organization.
In general, I would lean to forming an LLC because it’s very easy to setup, you can do it yourself, and the fees for setting it up (not counting California) are pretty inexpensive. You gain the limited liability that you need, and you get pass through accounting for profits and losses without the “double taxation” you have with a C-Corporation. Incfile
Sounds great, right? Well in most cases, it is, and this is is why you see so many businesses setup as LLCs today. My first business was an S-Corp, which offered many of the same benefits, but this was before LLCs even existed. Since then, all of my businesses have started as LLCs. As they grew, they changed to C-Corporations for reasons I’ll explain below.
First off, I guess for what type of entity to setup the main issue I had originally was whether to be an S corp or LLC. It seems those 2 would be the best ways to go for my buddy as far as protecting his personal assets and the pass through taxation. LLC seems a bit more flexible than S corp, but the LLC has to pay SE taxes, where I think the S corp either doesn’t (or gets to deduct them). Both LLC and S corp avoid the double taxation that a C corp would bring on, right?
LLCs vs. S-Corporations
S-Corporations are subject to many of the same record keeping and procedural requirements as C-Corporations, which is probably something you don’t want to mess around with. Likewise, there are also limitations on how you share profits and losses among the shareholders. You probably don’t want to mess with that, and LLCs allow you to avoid all that paperwork, and to split profits and losses however your LLC Operating Agreement dictates, regardless of actual shares held.
There are situations where you would want an S-Corp over an LLC, but those are somewhat rare and I’ve never seen a recent startup need to setup that way. Here again, an attorney might have good advice, but I’ll say with pretty high confidence that an LLC is the way to go over an S-Corp for a startup.
Now LLC vs. C-Corporation is a different matter, and might warrant some consideration…
LLCs vs. C-Corporations
The most obvious problem with C-Corporations is that they do not offer the pass through accounting that LLCs (or S-Corps) do, meaning that the Corporation will pay tax on any profits it has, the owner will be paid with a salary just like any other employee, on which they will pay taxes, and if you make profit distributions (by means of dividends), the shareholders will be taxed on that as well. I could easily climb on my soapbox and complain how taxation of dividends is double taxation on the exact same income, and how it leads corporations to make decisions that are not in the best interest of shareholders, and how it encourages gigantic, multi-national, and anti-competitive business evolution rather than profitable, innovative, smaller entities… but THAT is for another day (and probably another blog entirely!)
But, suffice it to say that the tax code is not friendly to the C-Corporation that wants to operate and then provide profits to the shareholders. If those shareholders also work there, then are three different points of taxation. LLCs look like they have only one, but in reality there is a secret second point of taxation because you have to pay self-employment tax in addition to income tax. Don’t you love how the government tries really hard to discourage people from working for themselves in the tax code, while paying lip service to how small business drives the economy? Ah, there I go again…
Anyway, paying self employment tax is still (most likely) cheaper than the C-Corp tax, because when you are paid as an employee, the C-Corp will need to make an employment tax withholding on your salary which is essentially the same as the self employment tax. One difference is that with the C-Corp, you might well hold profits in the corporation rather than pay them out, so if you were going to be highly profitable, you might be better served to hold profits there (and avoiding, for a while, the extra taxation) while paying yourself a minimal salary.
Now in a company that’s going to experience a period of losses as things ramp up, the LLC has advantages to the owner-operator. LLCs will pass those losses along, and those loses can offset other income the individual might have. In a C-corp, the corporation will carry those losses (for credit against future profits), but the owner-operator, who is an employee, does not get to take those losses. They will have W-2 income and will be taxed accordingly, just as they would if they were an employee at McDonalds or anyplace else.
So ready to jump right in as an LLC? Not so fast — there are a few more considerations…
The biggest limitation of LLCs, in my experience, is the very limited nature of how you deal with the ownership structure. LLCs do not have shareholders and shares of stock, they have “members” and “units” (nomenclature that is sure to make any fan of 9th grade humor to laugh uncontrollably). On the surface, it may seem that these are just different names for the same thing, but that’s not the case.
In an LLC, one member is the same as another member. Everyone is working under the same operating agreement, and if I have 100 units, and you have 100 units, there is no difference between us. An investor, the owner, other employees who have been given ownership — all these people hold exactly the same type of equity, the unit, and there is no difference between them. There is only one kind of unit in an LLC, and that’s that.