When starting a new business, one of the most important decisions you’ll make is choosing the right legal entity structure. The two most common structures for U.S. startups are C-Corporations (C-Corps) and Limited Liability Companies (LLCs). While both offer liability protection and other benefits, they differ in several key aspects, including taxation, management structure and ownership restrictions. In this post, we’ll examine the differences between C-Corps and LLCs, and help you determine which structure is the best fit for your business.
This article will establish the general principles. But remember two things: (1) every state is different and (2) every startup is different, so it’s best to work with your tax advisor and legal counsel to make your final decision. If you’re looking for legal counsel, feel free to reach out to us here.
Taxation
C-Corps and LLCs have different taxation structures.Â
C-Corps are taxed separately from their owners. The corporation must file its own tax return and pay taxes on its profits. If the corporation distributes dividends to its shareholders, those dividends are also subject to taxation at the individual level. This is known as double taxation.
LLCs are pass-through entities. All business income and losses flow through to the owners’ personal tax returns. LLC owners report their share of profits and losses on their individual tax returns and pay taxes at their personal income tax rate. This can be advantageous for some small businesses because it avoids double taxation at both the corporate and individual levels.
Ownership Restrictions
Significant differences exist between C-Corps and LLCs regarding ownership restrictions.Â
C-Corps have no limitations on the number of shareholders and do not impose restrictions on foreign ownership, meaning anyone can own shares in a C-Corp, regardless of their nationality or residency status.
LLCs, on the other hand, have limitations on their number of owners. Most states require LLCs to have fewer than 100 owners, although some states allow up to 1,000 owners. Additionally, some states ban foreign ownership of LLCs altogether or restrict the percentage of ownership that foreign individuals or entities can hold.
For small businesses with only a few owners or those that don’t intend to seek outside investment, these ownership restrictions may not be a concern. For startups looking to raise capital from investors or expand their operations internationally, however, these restrictions could be a significant consideration when choosing between a C-Corp and an LLC structure.
Management Structure
C-Corps and LLCs have different management structures.Â
By law, C-Corps must have a board of directors who oversee the company’s operations and make major decisions on behalf of shareholders. The board of directors is responsible for electing officers such as the chief executive officer (CEO), chief financial officer (CFO) and chief operating officer (COO), who manage day-to-day operations.
On the other hand, LLCs are more flexible. They can be managed by their members or by appointed managers. In member-managed LLCs, all owners are involved in running the business and making decisions. In manager-managed LLCs, designated individuals manage the company’s affairs while the members have a more passive role.
When choosing between a C-Corp and an LLC, startups should consider the difference in management structure. If a traditional corporate hierarchy with a board of directors overseeing executive management is preferred, a C-Corp may be the better choice. If a more flexible approach with owners taking active roles in decision-making or designated managers handling day-to-day operations is preferred, an LLC may be a better fit.
Raising Capital
If your startup is planning on raising venture capital, C-Corps have a significant advantage over LLCs.Â
Venture capitalists and angel investors are more familiar with the corporate structure of C-Corps and typically prefer to invest in them over LLCs. This is because C-Corps are the most common entity structure for a publicly traded company, and equity compensation for employees is much more straightforward.
On the other hand, LLCs may find it difficult to attract outside investment due to their pass-through taxation structure and ownership restrictions. While some investors may still be willing to invest in an LLC, they may require a higher rate of return or greater control over the company in exchange for their investment.
Startups that prioritize raising capital from outside investors should consider forming a C-Corp rather than an LLC. However, for businesses that plan to bootstrap, an LLC may be a more suitable option.
Formality Requirements
Formality requirements refer to the set of rules and regulations that corporations must comply with. C-Corps and LLCs differ in this area. C-Corps have more formalities to follow than LLCs, which can be both beneficial and challenging. On one hand, these formalities help establish the corporation as a separate legal entity from its owners, providing liability protection for shareholders. On the other hand, they can be time-consuming and expensive.
One of the most significant formality requirements for C-Corps is holding annual meetings of shareholders and directors. These meetings enable shareholders to vote on important matters, such as electing directors, approving bylaws or amendments, and issuing new shares of stock. In addition to holding meetings, C-Corps must keep detailed records of these meetings in the form of meeting minutes.
In contrast, LLCs have less strict formality requirements. They are not required to hold annual meetings or keep minutes of those meetings. While some states may require LLCs to file annual reports or pay franchise taxes, these requirements are typically less burdensome than those placed on C-Corps.
This difference in formality requirements can be an essential consideration for startups when choosing between a C-Corp and an LLC structure. For businesses that value structure and formal procedures, or plan to seek outside investment from venture capitalists or angel investors, a C-Corp may be a better fit. For businesses that prefer flexibility and fewer administrative burdens, or plan to self-fund their operations, an LLC may be more appropriate.
Profit Distribution
LLCs offer more flexibility than C-Corps when it comes to distributing profits among members. LLCs allow profits to be distributed equally among members or based on their percentage of ownership. Additionally, LLCs can choose to distribute profits at any time during the year, giving more flexibility and control over cash flow.
In contrast, C-Corps have a structured approach to distributing profits to shareholders. Dividends must be paid out in proportion to the number of shares owned by each shareholder. For example, if one shareholder owns 60% of the shares and another shareholder owns 40%, dividends must be paid out accordingly. Additionally, if C-Corps issue dividends, they are generally paid on a regular basis, typically quarterly or annually.
When deciding between a C-Corp and an LLC structure, startups should consider the differences in profit distribution. An LLC may be a better fit for businesses that value flexibility and control over profit distribution, or plan to reinvest profits back into the company’s growth. A C-Corp may be more appropriate for businesses that prefer a structured approach to profit distribution, or plan to pay regular dividends to shareholders.
Employee Benefits
C-Corps have an advantage over LLCs when it comes to employee benefits. C-Corps can offer more comprehensive packages, including stock options. These benefits can be attractive incentives for employees and help businesses attract top talent.
Stock options allow employees to purchase company shares at a discounted price, giving them a stake in the company’s success and the potential for financial gain if the company performs well. Additionally, C-Corps can offer retirement plans such as 401(k)s with employer-matching contributions, which can help employees save for their future while providing tax benefits.
On the other hand, LLCs have fewer options for employee benefits. While they may still be able to offer some benefits, such as health care or paid time off, they may not be able to provide comprehensive packages like C-Corps. This can make it more difficult for LLCs to compete with larger corporations in attracting top talent.
To offer comprehensive employee benefits, startups should consider forming a C-Corp rather than an LLC. However, if a business plans to keep its operations small and doesn’t require a large workforce, an LLC may still be a suitable option despite limited benefit offerings.
State Filing Fees
LLCs generally have an advantage over C-Corps when it comes to state filing fees. Most states charge lower fees for LLC formation and ongoing maintenance than they do for C-Corps. This is because LLCs are typically considered simpler and less formal business entities than C-Corps.
For example, in California, the filing fee to form an LLC is $70, while the fee to form a C-Corp is $100. In New York, the biennial statement fee (a required filing that all businesses must submit every two years) for an LLC is $9, while the fee for a C-Corp is $25.
Although state filing fees may appear to be a minor consideration when choosing between a C-Corp and an LLC structure, they can accumulate over time. For startups on a tight budget or those looking to minimize administrative expenses, choosing an LLC structure with lower state filing fees can be a wise financial decision.
Exit Strategy
When starting a business, it’s important to consider long-term goals and an exit strategy. C-Corporations are generally easier to sell or take public than Limited Liability Companies (LLCs), making them a popular choice for startups that plan to grow quickly and eventually go public.
One of the main reasons for this is that C-Corporations have a more established structure and are more familiar to investors than LLCs. Venture capitalists and other investors prefer investing in C-Corporations because they can issue multiple classes of stock with different voting rights and preferences, which can be an attractive incentive for investors looking for greater control over the company. This flexibility allows C-Corp founders to raise capital while retaining control over their company’s direction.
In contrast, LLCs may find it more difficult to attract outside investment due to their pass-through taxation structure and ownership restrictions. While some investors may still be willing to invest in an LLC, they may require a higher rate of return or greater control over the company in exchange for their investment.
Startups that prioritize rapid growth and eventual exit through sale or initial public offering (IPO) should consider forming a C-Corporation rather than an LLC. However, for businesses that plan to remain private or have no plans for rapid expansion, an LLC may be a more suitable option despite its limitations on an exit strategy.
